| Pub. 541, Partnerships |
2005 Tax Year |
Publication 541 - Main Contents
The following sections contain general information about partnerships.
Organizations Classified as Partnerships
An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes
if its members carry on a
trade, business, financial operation, or venture and divide its profits. However, a joint undertaking merely to share expenses
is not a partnership.
For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services
to the tenants.
The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed
after 1996.
Organizations formed after 1996.
An organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members
and it is none of the
following.
-
An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate,
or body
politic.
-
An organization formed under a state law that refers to it as a joint-stock company or joint-stock association.
-
An insurance company.
-
Certain banks.
-
An organization wholly owned by a state or local government.
-
An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly
traded
partnerships).
-
Certain foreign organizations identified in section 301.7701-2(b)(8) of the regulations.
-
A tax-exempt organization.
-
A real estate investment trust.
-
An organization classified as a trust under section 301.7701-4 of the regulations or otherwise subject to special treatment
under the
Internal Revenue Code.
-
Any other organization that elects to be classified as a corporation by filing Form 8832.
For more information, see the instructions for Form 8832.
Limited liability company.
A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC.
Unlike a partnership, none of
the members of an LLC are personally liable for its debts. An LLC may be classified for federal income tax purposes as either
a partnership, a
corporation, or an entity disregarded as an entity separate from its owner by applying the rules in regulations section 301.7701-3.
See Form 8832 and
section 301.7701-3 of the regulations for more details.
A domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax
purposes.
Organizations formed before 1997.
An organization formed before 1997 and classified as a partnership under the old rules will generally continue to
be classified as a partnership as
long as the organization has at least two members and does not elect to be classified as a corporation by filing Form 8832.
Community property.
A husband and wife who own a qualified entity (defined later) can choose to classify the entity as a partnership for
federal tax purposes by filing
the appropriate partnership tax returns. They can choose to classify the entity as a sole proprietorship by filing a Schedule
C (Form 1040) listing
one spouse as the sole proprietor. A change in reporting position will be treated for federal tax purposes as a conversion
of the entity.
A qualified entity is a business entity that meets all the following requirements.
-
The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country,
or a
possession of the United States.
-
No person other than one or both spouses would be considered an owner for federal tax purposes.
-
The business entity is not treated as a corporation.
For more information about community property, see Publication 555, Community Property. Publication 555 discusses
the community property laws of
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
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 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.
The partnership agreement includes the original agreement and any modifications. The modifications must be agreed to by all
partners or adopted in
any other manner provided by the partnership agreement. The agreement or modifications can be oral or written.
Partners can modify the partnership agreement for a particular tax year after the close of the year but not later than the
date for filing the
partnership return for that year. This filing date does not include any extension of time.
If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part
of the agreement.
Terminating a Partnership
A partnership terminates when one of the following events takes place.
-
All its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its
partners in a
partnership.
-
At least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including
a sale or
exchange to another partner.
Unlike other partnerships, an electing large partnership does not terminate on the sale or exchange of 50% or more of the
partnership interests
within a 12-month period.
See section 1.708-1(b) of the regulations for more information on the termination of a partnership. For special rules that
apply to a merger,
consolidation, or division of a partnership, see sections 1.708-1(c) and 1.708-1(d) of the regulations.
Date of termination.
The partnership's tax year ends on the date of termination. For the event described in (1), earlier, the date of termination
is the date the
partnership completes the winding up of its affairs. For the event described in (2), earlier, the date of termination is the
date of the sale or
exchange of a partnership interest that, by itself or together with other sales or exchanges in the preceding 12 months, transfers
an interest of 50%
or more in both capital and profits.
Short period return.
If a partnership is terminated before the end of the tax year, Form 1065 must be filed for the short period, which
is the period from the beginning
of the tax year through the date of termination. The return is due the 15th day of the fourth month following the date of
termination. See
Partnership Return (Form 1065), later, for information about filing Form 1065.
Conversion of partnership into limited liability company (LLC).
The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate
the partnership. The conversion
is not a sale, exchange, or liquidation of any partnership interest, the partnership's tax year does not close, and the LLC
can continue to use the
partnership's taxpayer identification number.
However, the conversion may change some of the partners' bases in their partnership interests if the partnership has
recourse liabilities that
become nonrecourse liabilities. Because the partners share recourse and nonrecourse liabilities differently, their bases must
be adjusted to reflect
the new sharing ratios. If a decrease in a partner's share of liabilities exceeds the partner's basis, he or she must recognize
gain on the excess.
For more information, see Effect of Partnership Liabilities under Basis of Partner's Interest, later.
The same rules apply if an LLC classified as a partnership is converted into a partnership.
IRS e-file (Electronic Filing)
Certain partnerships with more than 100 partners are required to file Form 1065, Schedules K-1, and related forms and schedules
electronically
(e-file). Other partnerships generally have the option to file electronically. For details about IRS e-file, see the Form 1065
instructions.
Exclusion From Partnership Rules
Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being
treated as partnerships
for federal income tax purposes. All the partners must agree to make the choice, and the partners must be able to compute
their own taxable income
without computing the partnership's income. However, the partners are not exempt from the rule that limits a partner's distributive
share of
partnership loss to the adjusted basis of the partner's partnership interest. Nor are they exempt from the requirement of
a business purpose for
adopting a tax year for the partnership that differs from its required tax year.
Investing partnership.
An investing partnership can be excluded if the participants in the joint purchase, retention, sale, or exchange of
investment property meet all
the following requirements.
-
They own the property as co-owners.
-
They reserve the right separately to take or dispose of their shares of any property acquired or retained.
-
They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase,
sell, or
exchange the investment property. Each separate participant can delegate authority to purchase, sell, or exchange his or her
share of the investment
property for the time being for his or her account, but not for a period of more than a year.
Operating agreement partnership.
An operating agreement partnership group can be excluded if the participants in the joint production, extraction,
or use of property meet all the
following requirements.
-
They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights.
-
They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used.
-
They do not jointly sell services or the property produced or extracted. Each separate participant can delegate authority
to sell his or her
share of the property produced or extracted for the time being for his or her account, but not for a period of time in excess
of the minimum needs of
the industry, and in no event for more than one year.
However, this exclusion does not apply to an unincorporated organization one of whose principal purposes is cycling, manufacturing,
or
processing for persons who are not members of the organization.
Electing the exclusion.
An eligible organization that wishes to be excluded from the partnership rules must make the election not later than
the time for filing the
partnership return for the first tax year for which exclusion is desired. This filing date includes any extension of time.
See section 1.761-2(b) of
the regulations for the procedures to follow.
Partnership Return (Form 1065)
Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing
its income,
deductions, and other required information. The partnership return must show the names and addresses of each partner and each
partner's distributive
share of taxable income. The return must be signed by a general partner. If a limited liability company is treated as a partnership,
it must file Form
1065 and one of its members must sign the return.
A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year
in which it neither
receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.
See the instructions for Form 1065 for more information about who must file Form 1065.
Partnership Distributions
Partnership distributions include the following.
-
A withdrawal by a partner in anticipation of the current year's earnings.
-
A distribution of the current year's or prior years' earnings not needed for working capital.
-
A complete or partial liquidation of a partner's interest.
-
A distribution to all partners in a complete liquidation of the partnership.
A partnership distribution is not taken into account in determining the partner's distributive share of partnership income
or loss. If any gain or
loss from the distribution is recognized by the partner, it must be reported on his or her return for the tax year in which
the distribution is
received. Money or property withdrawn by a partner in anticipation of the current year's earnings is treated as a distribution
received on the last
day of the partnership's tax year.
Effect on partner's basis.
A partner's adjusted basis in his or her partnership interest is decreased (but not below zero) by the money and adjusted
basis of property
distributed to the partner. See Adjusted Basis under Basis of Partner's Interest, later.
Effect on partnership.
A partnership generally does not recognize any gain or loss because of distributions it makes to partners. The partnership
may be able to elect to
adjust the basis of its undistributed property.
Certain distributions treated as a sale or exchange.
When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property
rather than a distribution.
-
Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's
interest in other
partnership property, including money.
-
Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or
substantially
appreciated inventory items.
See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later.
This treatment does not apply to the following distributions.
-
A distribution of property to the partner who contributed the property to the partnership.
-
Payments made to a retiring partner or successor in interest of a deceased partner that are the partner's distributive share
of partnership
income or guaranteed payments.
Substantially appreciated inventory items.
Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the
distribution, their total fair
market value is more than 120% of the partnership's adjusted basis for the property. However, if a principal purpose for acquiring
inventory property
is to avoid ordinary income treatment by reducing the appreciation to less than 120%, that property is excluded.
A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities
treated as money)
included in the distribution exceeds the adjusted basis of the partner's interest in the partnership. Any gain recognized
is generally treated as
capital gain from the sale of the partnership interest on the date of the distribution. If partnership property (other than
marketable securities
treated as money) is distributed to a partner, he or she generally does not recognize any gain until the sale or other disposition
of the property.
For exceptions to these rules, see Distribution of partner's debt and Net precontribution gain, later. Also, see
Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later.
Example.
The adjusted basis of Jo's partnership interest is $14,000. She receives a distribution of $8,000 cash and land that has an
adjusted basis of
$2,000 and a fair market value of $3,000. Because the cash received does not exceed the basis of her partnership interest,
Jo does not recognize any
gain on the distribution. Any gain on the land will be recognized when she sells or otherwise disposes of it. The distribution
decreases the adjusted
basis of Jo's partnership interest to $4,000 [$14,000 - ($8,000 + $2,000)].
Marketable securities treated as money.
Generally, a marketable security distributed to a partner is treated as money in determining whether gain is recognized
on the distribution. This
treatment, however, does not generally apply if that partner contributed the security to the partnership or an investment
partnership made the
distribution to an eligible partner.
The amount treated as money is the security's fair market value when distributed, reduced (but not below zero) by
the excess (if any) of:
-
The partner's distributive share of the gain that would be recognized had the partnership sold all its marketable securities
at their fair
market value immediately before the transaction resulting in the distribution, over
-
The partner's distributive share of the gain that would be recognized had the partnership sold all such securities it still
held after the
distribution at the fair market value in (1).
For more information, including the definition of marketable securities, see section 731(c) of the Internal Revenue
Code.
Loss on distribution.
A partner does not recognize loss on a partnership distribution unless all the following requirements are met.
-
The adjusted basis of the partner's interest in the partnership exceeds the distribution.
-
The partner's entire interest in the partnership is liquidated.
-
The distribution is in money, unrealized receivables, or inventory items.
There are exceptions to these general rules. See the following discussions. Also, see Liquidation at Partner's Retirement or Death under
Disposition of Partner's Interest, later.
Distribution of partner's debt.
If a partnership acquires a partner's debt and extinguishes the debt by distributing it to the partner, the partner
will recognize capital gain or
loss to the extent the fair market value of the debt differs from the basis of the debt (determined under the rules discussed
in Partner's Basis
for Distributed Property, later).
The partner is treated as having satisfied the debt for its fair market value. If the issue price (adjusted for any
premium or discount) of the
debt exceeds its fair market value when distributed, the partner may have to include the excess amount in income as canceled
debt.
Similarly, a deduction may be available to a corporate partner if the fair market value of the debt at the time of
distribution exceeds its
adjusted issue price.
Net precontribution gain.
A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed
appreciated property to the
partnership during the 7-year period before the distribution.
A 5-year period applies to property contributed before June 9, 1997, or under a written binding contract:
-
That was in effect on June 8, 1997, and at all times thereafter before the contribution, and
-
That provides for the contribution of a fixed amount of property.
The gain recognized is the lesser of the following amounts.
-
The excess of:
-
The fair market value of the property received in the distribution, over
-
The adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below
zero) by any
money received in the distribution.
-
The “net precontribution gain” of the partner. This is the net gain the partner would recognize if all the property contributed by the
partner within 7 years (5 years for property contributed before June 9, 1997) of the distribution, and held by the partnership
immediately before the
distribution, were distributed to another partner, other than a partner who owns more than 50% of the partnership. For information
about the
distribution of contributed property to another partner, see Contribution of Property, under Transactions Between Partnership and
Partners, later.
The character of the gain is determined by reference to the character of the net precontribution gain. This gain is
in addition to any gain the
partner must recognize if the money distributed is more than his or her basis in the partnership.
For these rules, the term “money” includes marketable securities treated as money, as discussed earlier.
Effect on basis.
The adjusted basis of the partner's interest in the partnership is increased by any net precontribution gain recognized
by the partner. Other than
for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. See Basis of Partner's Interest,
later.
The partnership must adjust its basis in any property the partner contributed within 7 years (5 years for property
contributed before June 9, 1997)
of the distribution to reflect any gain that partner recognizes under this rule.
Exceptions.
Any part of a distribution that is property the partner previously contributed to the partnership is not taken into
account in determining the
amount of the excess distribution or the partner's net precontribution gain. For this purpose, the partner's previously contributed
property does not
include a contributed interest in an entity to the extent its value is due to property contributed to the entity after the
interest was contributed to
the partnership.
Recognition of gain under this rule also does not apply to a distribution of unrealized receivables or substantially
appreciated inventory items if
the distribution is treated as a sale or exchange, as discussed earlier.
Partner's Basis for Distributed Property
Unless there is a complete liquidation of a partner's interest, the basis of property (other than money) distributed to the
partner by a
partnership is its adjusted basis to the partnership immediately before the distribution. However, the basis of the property
to the partner cannot be
more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction.
Example 1.
The adjusted basis of Beth's partnership interest is $30,000. She receives a distribution of property that has an adjusted
basis of $20,000 to the
partnership and $4,000 in cash. Her basis for the property is $20,000.
Example 2.
The adjusted basis of Mike's partnership interest is $10,000. He receives a distribution of $4,000 cash and property that
has an adjusted basis to
the partnership of $8,000. His basis for the distributed property is limited to $6,000 ($10,000 - $4,000, the cash he receives).
Complete liquidation of partner's interest.
The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's
interest in the partnership
reduced by any money distributed to the partner in the same transaction.
Partner's holding period.
A partner's holding period for property distributed to the partner includes the period the property was held by the
partnership. If the property
was contributed to the partnership by a partner, then the period it was held by that partner is also included.
Basis divided among properties.
If the basis of property received is the adjusted basis of the partner's interest in the partnership (reduced by money
received in the same
transaction), it must be divided among the properties distributed to the partner. For property distributed after August 5,
1997, allocate the basis
using the following rules.
-
Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to
each item equal
to the partnership's adjusted basis in the item immediately before the distribution. If the total of these assigned bases
exceeds the allocable basis,
decrease the assigned bases by the amount of the excess.
-
Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each
property equal
to the partnership's adjusted basis in the property immediately before the distribution. If the allocable basis exceeds the
total of these assigned
bases, increase the assigned bases by the amount of the excess. If the total of these assigned bases exceeds the allocable
basis, decrease the
assigned bases by the amount of the excess.
Allocating a basis increase.
Allocate any basis increase required in rule (2), above, first to properties with unrealized appreciation to the extent
of the unrealized
appreciation. (If the basis increase is less than the total unrealized appreciation, allocate it among those properties in
proportion to their
respective amounts of unrealized appreciation.) Allocate any remaining basis increase among all the properties in proportion
to their respective fair
market values.
Example.
Julie's basis in her partnership interest is $55,000. In a distribution in liquidation of her entire interest, she receives
properties A and B,
neither of which is inventory or unrealized receivables. Property A has an adjusted basis to the partnership of $5,000 and
a fair market value of
$40,000. Property B has an adjusted basis to the partnership of $10,000 and a fair market value of $10,000.
To figure her basis in each property, Julie first assigns bases of $5,000 to property A and $10,000 to property B (their adjusted
bases to the
partnership). This leaves a $40,000 basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned bases).
She first allocates
$35,000 to property A (its unrealized appreciation). The remaining $5,000 is allocated between the properties based on their
fair market values.
$4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is allocated to property B. Julie's basis
in property A is $44,000
($5,000 + $35,000 + $4,000) and her basis in property B is $11,000 ($10,000 + $1,000).
Allocating a basis decrease.
Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier.
-
Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. (If
the basis decrease
is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of
unrealized
depreciation.)
-
Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased
in (1)).
Example.
Tom's basis in his partnership interest is $20,000. In a distribution in liquidation of his entire interest, he receives properties
C and D,
neither of which is inventory or unrealized receivables. Property C has an adjusted basis to the partnership of $15,000 and
a fair market value of
$15,000. Property D has an adjusted basis to the partnership of $15,000 and a fair market value of $5,000.
To figure his basis in each property, Tom first assigns bases of $15,000 to property C and $15,000 to property D (their adjusted
bases to the
partnership). This leaves a $10,000 basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable basis).
He allocates the
entire $10,000 to property D (its unrealized depreciation). Tom's basis in property C is $15,000 and his basis in property
D is $5,000 ($15,000
- $10,000).
Distributions before August 6, 1997.
For property distributed before August 6, 1997, allocate the basis using the following rules.
-
Allocate the basis first to unrealized receivables and inventory items included in the distribution to the extent of the partnership's
adjusted basis in those items. If the partnership's adjusted basis in those items exceeded the allocable basis, allocate the
basis among the items in
proportion to their adjusted bases to the partnership.
-
Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership.
Partner's interest more than partnership basis.
If the basis of a partner's interest to be divided in a complete liquidation of the partner's interest is more than
the partnership's adjusted
basis for the unrealized receivables and inventory items distributed, and if no other property is distributed to which the
partner can apply the
remaining basis, the partner has a capital loss to the extent of the remaining basis of the partnership interest.
Special adjustment to basis.
A partner who acquired any part of his or her partnership interest in a sale or exchange or upon the death of another
partner may be able to choose
a special basis adjustment for property distributed by the partnership. To choose the special adjustment, the partner must
have received the
distribution within 2 years after acquiring the partnership interest. Also, the partnership must not have chosen the optional
adjustment to basis when
the partner acquired the partnership interest.
If a partner chooses this special basis adjustment, the partner's basis for the property distributed is the same as
it would have been if the
partnership had chosen the optional adjustment to basis. However, this assigned basis is not reduced by any depletion or depreciation
that would have
been allowed or allowable if the partnership had previously chosen the optional adjustment.
The choice must be made with the partner's tax return for the year of the distribution if the distribution includes
any property subject to
depreciation, depletion, or amortization. If the choice does not have to be made for the distribution year, it must be made
with the return for the
first year in which the basis of the distributed property is pertinent in determining the partner's income tax.
A partner choosing this special basis adjustment must attach a statement to his or her tax return that the partner
chooses under section 732(d) of
the Internal Revenue Code to adjust the basis of property received in a distribution. The statement must show the computation
of the special basis
adjustment for the property distributed and list the properties to which the adjustment has been allocated.
Example.
Bob purchased a 25% interest in X partnership for $17,000 cash. At the time of the purchase, the partnership owned inventory
having a basis to the
partnership of $14,000 and a fair market value of $16,000. Thus, $4,000 of the $17,000 he paid was attributable to his share
of inventory with a basis
to the partnership of $3,500.
Within 2 years after acquiring his interest, Bob withdrew from the partnership and for his entire interest received cash of
$1,500, inventory with
a basis to the partnership of $3,500, and other property with a basis of $6,000. The value of the inventory received was 25%
of the value of all
partnership inventory. (It is immaterial whether the inventory he received was on hand when he acquired his interest.)
Since the partnership from which Bob withdrew did not make the optional adjustment to basis, he chose to adjust the basis
of the inventory
received. His share of the partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference between
the $16,000 fair market
value of the inventory and its $14,000 basis to the partnership at the time he acquired his interest). The adjustment applies
only for purposes of
determining his new basis in the inventory, and not for purposes of partnership gain or loss on disposition.
The total to be allocated among the properties Bob received in the distribution is $15,500 ($17,000 basis of his interest
- $1,500 cash
received). His basis in the inventory items is $4,000 ($3,500 partnership basis + $500 special adjustment). The remaining
$11,500 is allocated to his
new basis for the other property he received.
Mandatory adjustment.
A partner does not always have a choice of making this special adjustment to basis. The special adjustment to basis
must be made for a distribution
of property, (whether or not within 2 years after the partnership interest was acquired) if all the following conditions existed
when the partner
received the partnership interest.
-
The fair market value of all partnership property (other than money) was more than 110% of its adjusted basis to the
partnership.
-
If there had been a liquidation of the partner's interest immediately after it was acquired, an allocation of the basis of
that interest
under the general rules (discussed earlier under Basis divided among properties) would have decreased the basis of property that could not
be depreciated, depleted, or amortized and increased the basis of property that could be.
-
The optional basis adjustment, if it had been chosen by the partnership, would have changed the partner's basis for the property
actually
distributed.
Required statement.
Generally, if a partner chooses a special basis adjustment and notifies the partnership, or if the partnership makes
a distribution for which the
special basis adjustment is mandatory, the partnership must provide a statement to the partner. The statement must provide
information necessary for
the partner to compute the special basis adjustment.
Marketable securities.
A partner's basis in marketable securities received in a partnership distribution, as determined in the preceding
discussions, is increased by any
gain recognized by treating the securities as money. See Marketable securities treated as money under Partner's Gain or Loss,
earlier. The basis increase is allocated among the securities in proportion to their respective amounts of unrealized appreciation
before the
basis increase.
Transactions Between Partnership and Partners
For certain transactions between a partner and his or her partnership, the partner is treated as not being a member of the
partnership. These
transactions include the following.
-
Performing services for or transferring property to a partnership if—
-
There is a related allocation and distribution to a partner, and
-
The entire transaction, when viewed together, is properly characterized as occurring between the partnership and a partner
not acting in the
capacity of a partner.
-
Transferring money or other property to a partnership if—
-
There is a related transfer of money or other property by the partnership to the contributing partner or another partner,
and
-
The transfers together are properly characterized as a sale or exchange of property.
Payments by accrual basis partnership to cash basis partner.
A partnership that uses an accrual method of accounting cannot deduct any business expense owed to a cash basis partner
until the amount is paid.
However, this rule does not apply to guaranteed payments made to a partner, which are generally deductible when accrued.
Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income.
A partnership
treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner.
This treatment is for
purposes of determining gross income and deductible business expenses only. For other tax purposes, guaranteed payments are
treated as a partner's
distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.
The partnership generally deducts guaranteed payments on line 10 of Form 1065 as a business expense. They are also listed
on Schedules K and K-1 of
the partnership return. The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along
with his or her
distributive share of the partnership's other ordinary income.
Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital
expenses. Generally,
organizational and syndication expenses are not deductible by the partnership. However, a partnership can elect to deduct
a portion of its
organizational expenses and amortize the remaining expenses (see Business start-up and organizational costs in the instructions for Form
1065). Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on
the partners' Schedule K-1
as guaranteed payments.
Minimum payment.
If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the
minimum payment is more than
the partner's distributive share of the partnership income before taking into account the guaranteed payment.
Example.
Under a partnership agreement, Sandy is to receive 30% of the partnership income, but not less than $8,000. The partnership
has net income of
$20,000. Sandy's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). The guaranteed payment that can
be deducted by the
partnership is $2,000 ($8,000 - $6,000). Sandy's income from the partnership is $8,000, and the remaining $12,000 of partnership
income will be
reported by the other partners in proportion to their shares under the partnership agreement.
If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard
to the guarantee, would
have been greater than the guarantee.
Self-employed health insurance premiums.
Premiums for health insurance paid by a partnership on behalf of a partner for services as a partner are treated as
guaranteed payments. The
partnership can deduct the payments as a business expense and the partner must include them in gross income. However, if the
partnership accounts for
insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums.
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.
Including payments in partner's income.
Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends.
Example 1.
Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income
of the partnership.
Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the
guaranteed payment. She
must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual
income tax
return for her tax year in which the partnership's tax year ends.
Example 2.
Mike is a calendar year taxpayer who is a partner in a partnership. The partnership uses a fiscal year that ended January
31, 2005. Mike received
guaranteed payments from the partnership from February 1, 2004, until December 31, 2004. He must include these guaranteed
payments in income for 2005
and report them on his 2005 income tax return.
Payments resulting in loss.
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.
Sale or Exchange of Property
Special rules apply to a sale or exchange of property between a partnership and certain persons.
Losses.
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.
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.
-
More than 50% of the capital or profits interest in the partnership(s) is directly or indirectly owned by the same person(s).
-
The property in the hands of the transferee immediately after the transfer is not a capital asset. Property that is not a
capital asset
includes accounts receivable, inventory, stock-in-trade, and depreciable or real property used in a trade or business.
More than 50% ownership.
To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply.
-
An interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered to be owned
proportionately by
or for its shareholders, partners, or beneficiaries.
-
An individual is considered to own the interest directly or indirectly owned by or for the individual's family. For this rule,
“family”
includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants.
-
If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning
that interest when rules (1) and (2) are applied. However, if a person is considered to own an interest using rule (2), that
person is not treated as
actually owning that interest in reapplying rule (2) to make another person the constructive owner.
Example.
Individuals A and B and Trust T are equal partners in Partnership ABT. A's husband, AH, is the sole beneficiary of Trust T.
Trust T's partnership
interest will be attributed to AH only for the purpose of further attributing the interest to A. As a result, A is a more-than-50%
partner. This means
that any deduction for losses on transactions between her and ABT will not be allowed, and gain from property that in the
hands of the transferee is
not a capital asset is treated as ordinary, rather than capital, gain.
More information.
For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Publication 544.
Usually, neither the partner nor the partnership recognizes a gain or loss when property is contributed to the partnership
in exchange for a
partnership interest. This applies whether a partnership is being formed or is already operating. The partnership's holding
period for the property
includes the partner's holding period.
The contribution of limited partnership interests in one partnership for limited partnership interests in another partnership
qualifies as a
tax-free contribution of property to the second partnership if the transaction is made for business purposes. The exchange
is not subject to the rules
explained later under Disposition of Partner's Interest.
Disguised sales.
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.
Form 8275 required.
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.
-
A caption identifying the statement as a disclosure under section 707 of the Internal Revenue Code.
-
A description of the transferred property or money, including its value.
-
A description of any relevant facts in determining if the transfers are properly viewed as a disguised sale. (See section
1.707-3(b)(2) of
the regulations for a description of the facts and circumstances considered in determining if the transfers are a disguised
sale.)
Contribution to investment company.
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.
Contribution to foreign partnership.
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.
-
Immediately after the contribution, the partnership owned, directly or indirectly, at least a 10% interest in the foreign
partnership.
-
The fair market value of the property contributed to the foreign partnership, when added to other contributions of property
made to the
partnership during the preceding 12-month period, is greater than $100,000.
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.
Basis of contributed property.
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.
Allocations to account for built-in gain or loss.
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.
Example.
Sara and Gail formed an equal partnership. Sara contributed $10,000 in cash to the partnership and Gail contributed depreciable
property with a
fair market value of $10,000 and an adjusted basis of $4,000. The partnership's basis for depreciation is limited to the adjusted
basis of the
property in Gail's hands, $4,000.
In effect, Sara purchased an undivided one-half interest in the depreciable property with her contribution of $10,000. Assuming
that the
depreciation rate is 10% a year under the General Depreciation System (GDS), she would have been entitled to a depreciation
deduction of $500 per
year, based on her interest in the partnership, if the adjusted basis of the property equaled its fair market value when contributed.
(To simplify
this example, the depreciation deductions are determined without regard to any first-year depreciation conventions.)
However, since the partnership is allowed only $400 per year of depreciation (10% of $4,000), no more than $400 can be allocated
between the
partners. The entire $400 must be allocated to Sara.
Distribution of contributed property to another partner.
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:
-
That was in effect on June 8, 1997, and at all times thereafter before the contribution, and
-
That provides for the contribution of a fixed amount of property.
The 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.
Disposition of certain contributed property.
The following rules determine the character of the partnership's gain or loss on a disposition of certain types of
contributed property.
-
Unrealized receivables. If the property was an unrealized receivable in the hands of the contributing partner, any gain or loss
on its disposition by the partnership is ordinary income or loss. Unrealized receivables are defined later under Payments for Unrealized
Receivables and Inventory Items. When reading the definition, substitute “partner” for “partnership.”
-
Inventory items. If the property was an inventory item in the hands of the contributing partner, any gain or loss on its
disposition by the partnership within 5 years after the contribution is ordinary income or loss. Inventory items are defined
later in Payments
for Unrealized Receivables and Inventory Items.
-
Capital loss property. If the property was a capital asset in the contributing partner's hands, any loss on its disposition by
the partnership within 5 years after the contribution is a capital loss. The capital loss is limited to the amount by which
the partner's adjusted
basis for the property exceeded the property's fair market value immediately before the contribution.
-
Substituted basis property. If the disposition of any of the property listed in (1), (2), or (3) is a nonrecognition transaction,
these rules apply when the recipient of the property disposes of any substituted basis property (other than certain corporate
stock) resulting from
the transaction.
A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed.
Capital interest.
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.
Profits interest.
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.
-
The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as
income from
high-quality debt securities or a high-quality net lease.
-
Within 2 years of receipt, the partner disposes of the profits interest.
-
The profits interest is a limited partnership interest in a publicly traded partnership.
A profits interest transferred as compensation for services is not subject to the rules for restricted property that
apply to capital interests.
Basis of Partner's Interest
The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. If the partner
must recognize
gain as a result of the contribution, this gain is included in the basis of his or her interest. Any increase in a partner's
individual liabilities
because of an assumption of partnership liabilities is considered a contribution of money to the partnership by the partner.
Interest acquired by gift, etc.
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.
There is a worksheet for adjusting the basis of a partner's interest in the partnership in the Partner's Instructions for
Schedule K-1 (Form 1065).
The basis of an interest in a partnership is increased or decreased by certain items.
Increases.
A partner's basis is increased by the following items.
-
The partner's additional contributions to the partnership, including an increased share of or assumption of partnership
liabilities.
-
The partner's distributive share of taxable and nontaxable partnership income.
-
The partner's distributive share of the excess of the deductions for depletion over the basis of the depletable property,
unless the
property is oil or gas wells whose basis has been allocated to partners.
Decreases.
The partner's basis is decreased (but never below zero) by the following items.
-
The money (including a decreased share of partnership liabilities or an assumption of the partner's individual liabilities
by the
partnership) and adjusted basis of property distributed to the partner by the partnership.
-
The partner's distributive share of the partnership losses (including capital losses).
-
The partner's distributive share of nondeductible partnership expenses that are not capital expenditures. This includes the
partner's share
of any section 179 expenses, even if the partner cannot deduct the entire amount on his or her individual income tax return.
-
The partner's deduction for depletion for any partnership oil and gas wells, up to the proportionate share of the adjusted
basis of the
wells allocated to the partner.
Partner's liabilities assumed by partnership.
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.
Example 1.
John acquired a 20% interest in a partnership by contributing property that had an adjusted basis to him of $8,000 and a $4,000
mortgage. The
partnership assumed payment of the mortgage. The basis of John's interest is:
Example 2.
If, in Example 1, the contributed property had a $12,000 mortgage, the basis of John's partnership interest would be zero.
The $1,600 difference
between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital
gain from the
sale or exchange of a partnership interest. However, this gain would not increase the basis of his partnership interest.
Book value of partner's interest.
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.
Example.
Sam contributes to his partnership property that has an adjusted basis of $400 and a fair market value of $1,000. His partner
contributes $1,000
cash. While each partner has increased his capital account by $1,000, which will be reflected in the partnership books, the
adjusted basis of Sam's
interest is only $400 and the adjusted basis of his partner's interest is $1,000.
When determined.
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.
Alternative rule for figuring adjusted basis.
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.
-
The circumstances are such that the partner cannot practicably apply the general basis rules.
-
It is, in the opinion of the IRS, reasonable to conclude that the result produced will not vary substantially from the result
under the
general basis rules.
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.
Effect of Partnership Liabilities
A partner's basis in a partnership interest includes the partner's share of a partnership liability only if, and to the extent
that, the liability:
-
Creates or increases the partnership's basis in any of its assets,
-
Gives rise to a current deduction to the partnership, or
-
Is a nondeductible, noncapital expense of the partnership.
The term “assets” in (1) includes capitalized items allocable to future periods, such as organization expenses.
A partner's share of accrued but unpaid expenses or accounts payable of a cash basis partnership are not included in the adjusted
basis of the
partner's interest in the partnership.
Partner's basis increased.
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.
Partner's basis decreased.
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.
Assumption of liability.
A partner or related person is considered to assume a partnership liability only to the extent that:
-
He or she is personally liable for it,
-
The creditor knows that the liability was assumed by the partner or related person,
-
The creditor can demand payment from the partner or related person, and
-
No other partner or person related to another partner will bear the economic risk of loss on that liability immediately after
the
assumption.
Related person.
Related persons, for these purposes, includes all the following.
-
An individual and his or her spouse, ancestors, and lineal descendants.
-
An individual and a corporation if the individual directly or indirectly owns 80% or more in value of the outstanding stock
of the
corporation.
-
Two corporations that are members of the same controlled group.
-
A grantor and a fiduciary of any trust.
-
Fiduciaries of two separate trusts if the same person is a grantor of both trusts.
-
A fiduciary and a beneficiary of the same trust.
-
A fiduciary and a beneficiary of two separate trusts if the same person is a grantor of both trusts.
-
A fiduciary of a trust and a corporation if the trust or the grantor of the trust directly or indirectly owns 80% or more
in value of the
outstanding stock of the corporation.
-
A person and a tax-exempt educational or charitable organization controlled directly or indirectly by the person or by members
of the
person's family.
-
A corporation and a partnership if the same persons own 80% or more in value of the outstanding stock of the corporation and
80% or more of
the capital or profits interest in the partnership.
-
Two S corporations or an S corporation and a C corporation if the same persons own 80% or more in value of the outstanding
stock of each
corporation.
-
An executor and a beneficiary of an estate.
-
A partnership and a person owning, directly or indirectly, 80% or more of the capital or profits interest in the partnership.
-
Two partnerships if the same persons directly or indirectly own 80% or more of the capital or profits interests.
Property subject to a liability.
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.
Partner's share of recourse liabilities.
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.
Constructive liquidation.
Generally, in a constructive liquidation, the following events are treated as occurring at the same time.
-
All partnership liabilities become payable in full.
-
All of the partnership's assets have a value of zero, except for property contributed to secure a liability.
-
All property is disposed of by the partnership in a fully taxable transaction for no consideration (except relief from liabilities
for which
the creditor's right to reimbursement is limited solely to one or more assets of the partnership).
-
All items of income, gain, loss, or deduction are allocated to the partners.
-
The partnership liquidates.
Example.
Ted and Jane form a cash basis general partnership with cash contributions of $20,000 each. Under the partnership agreement,
they share all
partnership profits and losses equally. They borrow $60,000 and purchase depreciable business equipment. This debt is included
in the partners' basis
in the partnership because incurring it creates an additional $60,000 of basis in the partnership's depreciable property.
If neither partner has an economic risk of loss in the liability, it is a nonrecourse liability. Each partner's basis would
include his or her
share of the liability, $30,000.
If Jane is required to pay the creditor if the partnership defaults, she has an economic risk of loss in the liability. Her
basis in the
partnership would be $80,000 ($20,000 + $60,000), while Ted's basis would be $20,000.
Limited partner.
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.
Partner's share of nonrecourse 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.
More information.
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.
Disposition of Partner's Interest
The following discussions explain the treatment of gain or loss from the disposition of an interest in a partnership.
Abandoned or worthless partnership interest.
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.
Partnership election to adjust basis of partnership property.
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.
Sale, Exchange, or Other Transfer
The sale or exchange of a partner's interest in a partnership usually results in capital gain or loss. However, see Payments for Unrealized
Receivables and Inventory Items, later, for certain exceptions. Gain or loss is the difference between the amount realized and the adjusted
basis of the partner's interest in the partnership. If the selling partner is relieved of any partnership liabilities, that
partner must include the
liability relief as part of the amount realized for his or her interest.
Example 1.
Fred became a limited partner in the ABC Partnership by contributing $10,000 in cash on the formation of the partnership.
The adjusted basis of his
partnership interest at the end of the current year is $20,000, which includes his $15,000 share of partnership liabilities.
The partnership has no
unrealized receivables or inventory items. Fred sells his interest in the partnership for $10,000 in cash. He had been paid
his share of the
partnership income for the tax year.
Fred realizes $25,000 from the sale of his partnership interest ($10,000 cash payment + $15,000 liability relief). He reports
$5,000 ($25,000
realized - $20,000 basis) as a capital gain.
Example 2.
The facts are the same as in Example 1, except that Fred withdraws from the partnership when the adjusted basis of his interest
in the partnership
is zero. He is considered to have received a distribution of $15,000, his relief of liability. He reports a capital gain of
$15,000.
Exchange of partnership interests.
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.
Installment reporting for sale of partnership interest.
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.
Payments for Unrealized Receivables and Inventory Items
If a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share
of the partnership's
unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received
for the sale or exchange
of property that is not a capital asset.
This treatment applies to the unrealized receivables part of payments to a retiring partner or successor in interest of a
deceased partner only if
that part is not treated as paid in exchange for partnership property. See Liquidation at Partner's Retirement or Death, later.
Unrealized receivables.
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.
Other items treated as unrealized receivables.
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.
-
Mining property for which exploration expenses were deducted.
-
Stock in a Domestic International Sales Corporation (DISC).
-
Certain farm land for which expenses for soil and water conservation or land clearing were deducted.
-
Franchises, trademarks, or trade names.
-
Oil, gas, or geothermal property for which intangible drilling and development costs were deducted.
-
Stock of certain controlled foreign corporations.
-
Market discount bonds and short-term obligations.
-
Property subject to recapture of depreciation under sections 1245 and 1250 of the Internal Revenue Code. Depreciation recapture
is discussed
in chapter 3 of Publication 544.
Determining gain or loss.
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.
Example.
You are a partner in ABC Partnership. The adjusted basis of your partnership interest at the end of the current year is zero.
Your share of
potential ordinary income from partnership depreciable property is $5,000. The partnership has no other unrealized receivables
or inventory items. You
sell your interest in the partnership for $10,000 in cash and you report the entire amount as a gain since your adjusted basis
in the partnership is
zero. You report as ordinary income your $5,000 share of potential ordinary income from the partnership's depreciable property.
The remaining $5,000
gain is a capital gain.
Inventory items.
Inventory items are not just stock-in-trade of the partnership. They also include the following property.
-
Property that would properly be included in the partnership's inventory if on hand at the end of the tax year or that is held
primarily for
sale to customers in the normal course of business.
-
Property that, if sold or exchanged by the partnership, would not be a capital asset or section 1231 property (real or depreciable
business
property held more than one year). For example, accounts receivable acquired for services or from the sale of inventory and
unrealized receivables are
inventory items.
-
Property held by the partnership that would be considered inventory if held by the partner selling the partnership interest
or receiving the
distribution.
Notification required of partner.
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.
Information return required of partnership.
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.
Statement required of partner.
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.
-
The date of the sale or exchange.
-
The amount of any gain or loss attributable to the unrealized receivables or inventory.
-
The amount of any gain or loss attributable to capital gain or loss on the sale of the partnership interest.
Partner's disposition of distributed unrealized receivables or inventory items.
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.
Example.
Mike, a distributee partner, received his share of accounts receivable when his law firm dissolved. The partnership used the
cash method of
accounting, so the receivables had a basis of zero. If Mike later collects the receivables or sells them, the amount he receives
will be ordinary
income.
Exception for inventory items held more than 5 years.
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.
Example.
Ann receives, through dissolution of her partnership, inventory that has a basis of $19,000. Within 5 years, she sells the
inventory for $24,000.
The $5,000 gain is taxed as ordinary income. If she had held the inventory for more than 5 years, her gain would have been
capital gain, provided the
inventory was a capital asset in her hands at the time of sale.
Substituted basis property.
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.
Liquidation at Partner's Retirement or Death
Payments made by the partnership to a retiring partner or successor in interest of a deceased partner in return for the partner's
entire interest
in the partnership may have to be allocated between payments in liquidation of the partner's interest in partnership property
and other payments. The
partnership's payments include an assumption of the partner's share of partnership liabilities treated as a distribution of
money.
For income tax purposes, a retiring partner or successor in interest of a deceased partner is treated as a partner until his
or her interest in the
partnership has been completely liquidated.
Liquidating payments.
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.
Unrealized receivables and goodwill.
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.
-
Capital is not a material income-producing factor for the partnership. (Whether capital is a material income-producing factor
is explained
in the discussion under Family Partnership near the beginning of this publication.)
-
The retiring or deceased partner was a general partner in the partnership.
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.
Partners' valuation.
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.
Gain or loss on distribution.
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.
Other payments.
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.
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.
You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get information from
the IRS in several
ways. By selecting the method that is best for you, you will have quick and easy access to tax help.
Contacting your Taxpayer Advocate.
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:
-
Call the Taxpayer Advocate toll free at
1-877-777-4778.
-
Call, write, or fax the Taxpayer Advocate office in your area.
-
Call 1-800-829-4059 if you are a
TTY/TDD user.
-
Visit
www.irs.gov/advocate.
For more information, see Publication 1546, How To Get Help With Unresolved Tax Problems (now available in Chinese,
Korean, Russian, and
Vietnamese, in addition to English and Spanish).
Free tax services.
To find out what services are available, get Publication 910, IRS 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.
Internet. You can access the IRS website 24 hours a day, 7 days a week, at
www.irs.gov to:
-
E-file your return. Find out about commercial tax preparation and e-file services available free to eligible
taxpayers.
-
Check the status of your refund. Click on Where's My Refund. Be sure to wait at least 6 weeks from the date you filed your return
(3 weeks if you filed electronically). Have your tax return available because you will need to know your social security number,
your filing status,
and the exact whole dollar amount of your refund.
-
Download forms, instructions, and publications.
-
Order IRS products online.
-
Research your tax questions online.
-
Search publications online by topic or keyword.
-
View Internal Revenue Bulletins (IRBs) published in the last few years.
-
Figure your withholding allowances using our Form W-4 calculator.
-
Sign up to receive local and national tax news by email.
-
Get information on starting and operating a small business.
Phone. Many services are available by phone.
-
Ordering forms, instructions, and publications. Call 1-800-829-3676 to order current-year forms, instructions, and publications
and prior-year forms and instructions. You should receive your order within 10 days.
-
Asking tax questions. Call the IRS with your tax questions at 1-800-829-1040.
-
Solving problems. You can get face-to-face help solving tax problems every business day in IRS Taxpayer Assistance Centers. An
employee can explain IRS letters, request adjustments to your account, or help you set up a payment plan. Call your local
Taxpayer Assistance Center
for an appointment. To find the number, go to
www.irs.gov/localcontacts or
look in the phone book under United States Government, Internal Revenue Service.
-
TTY/TDD equipment. If you have access to TTY/TDD equipment, call 1-800-829-4059 to ask tax questions or to order forms and
publications.
-
TeleTax topics. Call 1-800-829-4477 and press 2 to listen to pre-recorded messages covering various tax topics.
-
Refund information. If you would like to check the status of your refund, call 1-800-829-4477 and press 1 for automated refund
information or call 1-800-829-1954. Be sure to wait at least 6 weeks from the date you filed your return (3 weeks if you filed
electronically). Have
your tax return available because you will need to know your social security number, your filing status, and the exact whole
dollar amount of your
refund.
Evaluating the quality of our telephone services. To ensure that IRS representatives give accurate, courteous, and professional answers,
we use several methods to evaluate the quality of our telephone services. One method is for a second IRS representative to
sometimes listen in on or
record telephone calls. Another is to ask some callers to complete a short survey at the end of the call.
Walk-in. Many products and services are available on a walk-in basis.
-
Products. You can walk in to many post offices, libraries, and IRS offices to pick up certain forms, instructions, and
publications. Some IRS offices, libraries, grocery stores, copy centers, city and county government offices, credit unions,
and office supply stores
have a collection of products available to print from a CD-ROM or photocopy from reproducible proofs. Also, some IRS offices
and libraries have the
Internal Revenue Code, regulations, Internal Revenue Bulletins, and Cumulative Bulletins available for research purposes.
-
Services. You can walk in to your local Taxpayer Assistance Center every business day for personal, face-to-face tax help. An
employee can explain IRS letters, request adjustments to your tax account, or help you set up a payment plan. If you need
to resolve a tax problem,
have questions about how the tax law applies to your individual tax return, or you're more comfortable talking with someone
in person, visit your
local Taxpayer Assistance Center where you can spread out your records and talk with an IRS representative face-to-face. No
appointment is necessary,
but if you prefer, you can call your local Center and leave a message requesting an appointment to resolve a tax account issue.
A representative will
call you back within 2 business days to schedule an in-person appointment at your convenience. To find the number, go to
www.irs.gov/localcontacts or
look in the phone book under United States Government, Internal Revenue Service.
Mail. You can send your order for forms, instructions, and publications to the address below and receive a response within 10 business
days after your request is received.
National Distribution Center
P.O. Box 8903
Bloomington, IL 61702-8903
CD-ROM for tax products. You can order Publication 1796, IRS Tax Products CD-ROM, and obtain:
-
A CD that is released twice so you have the latest products. The first release ships in late December and the final release
ships in late
February.
-
Current-year forms, instructions, and publications.
-
Prior-year forms, instructions, and publications.
-
Tax Map: an electronic research tool and finding aid.
-
Tax law frequently asked questions (FAQs).
-
Tax Topics from the IRS telephone response system.
-
Fill-in, print, and save features for most tax forms.
-
Internal Revenue Bulletins.
-
Toll-free and email technical support.
Buy the CD-ROM from National Technical Information Service (NTIS) at
www.irs.gov/cdorders for $25 (no handling fee) or call 1-877-233-6767 toll free to buy the CD-ROM for $25 (plus a $5 handling fee).
CD-ROM for small businesses. Publication 3207, The Small Business Resource Guide CD-ROM, has a new look and enhanced navigation
features. This year's CD includes:
-
Helpful information, such as how to prepare a business plan, find financing for your business, and much more.
-
All the business tax forms, instructions, and publications needed to successfully manage a business.
-
Tax law changes for 2005.
-
IRS Tax Map to help you find forms, instructions, and publications by searching on a keyword or topic.
-
Web links to various government agencies, business associations, and IRS organizations.
-
“Rate the Product” survey—your opportunity to suggest changes for future editions.
An updated version of this CD is available each year in early April. You can get a free copy by calling 1-800-829-3676 or
by visiting
www.irs.gov/smallbiz.
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