Partnership Taxation: Basis, Contributions and Distributions
By SimplyCPA · 11 October 2026
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- Flow-through: A partnership files Form 1065 but pays no income tax; each partner reports its share of income, deductions and credits from Schedule K-1.
- Contributions: Generally tax-free (Section 721). The partnership takes the partner's basis in the property (inside basis); the partner's interest takes the same basis (outside basis).
- Outside basis: Increases with contributions, share of income and share of partnership liabilities; decreases with distributions, losses and reductions in liabilities.
- Losses: Deductible only to the extent of outside basis, then the at-risk rules, then the passive activity rules, then the excess business loss limit.
- Distributions: Generally tax-free — gain arises only when cash (including deemed cash from liability relief) exceeds outside basis.
How a partnership is taxed
A partnership is a pass-through entity. It files an information return, Form 1065 (due on the 15th day of the third month after year-end — March 15 for calendar-year partnerships), and gives each partner a Schedule K-1. Partners pay tax on their distributive share whether or not cash is distributed. Items with special character — capital gains, Section 1231 gains, charitable contributions, Section 179 expense — are separately stated so they keep that character on the partner's return.
Contributions (Section 721)
- No gain or loss is recognised when property is contributed in exchange for a partnership interest.
- Inside basis: the partnership's basis in the property equals the partner's adjusted basis (Section 723), and its holding period tacks.
- Outside basis: the partner's basis in the interest equals cash plus the adjusted basis of property contributed (Section 722).
- Exceptions: contributing services for a capital interest is taxable compensation; and if a partner is relieved of liabilities exceeding its basis, the excess is gain.
- Built-in gain or loss on contributed property is allocated back to the contributing partner when recognised (Section 704(c)).
Liabilities (Section 752)
An increase in a partner's share of partnership liabilities is treated as a cash contribution (increasing outside basis). A decrease is a deemed cash distribution.
Example — contribution with a mortgage: A contributes land (basis $40,000, fair value $100,000) subject to a $30,000 mortgage to a new partnership for a 25% interest. The partnership assumes the mortgage.
A's outside basis = $40,000 − $30,000 (liability relieved) + 25% × $30,000 (A's share of the partnership's new liability) = $17,500. Because the net relief ($22,500) doesn't exceed A's basis, no gain is recognised.
Adjusting outside basis each year
Opening basis + contributions + share of income (including tax-exempt income) + increase in share of liabilities − distributions − decrease in share of liabilities − share of losses and non-deductible expenses. Basis can't go below zero.
The loss limitation ordering
- Basis (Section 704(d)) — losses beyond outside basis are suspended until basis is restored.
- At-risk (Section 465).
- Passive activity (Section 469).
- Excess business loss (Section 461(l)) for non-corporate taxpayers.
Distributions
| Current (non-liquidating) | Liquidating | |
|---|---|---|
| Gain to partner | Only if money distributed (including deemed distributions from liability relief) exceeds outside basis | Same |
| Loss to partner | Never | Only if the partner receives nothing but money, unrealised receivables and inventory, and their basis is less than outside basis |
| Basis of property received | The partnership's basis, but limited to the partner's remaining outside basis after cash | The partner's remaining outside basis is allocated among the properties received |
| Order of basis allocation | Money first, then unrealised receivables and inventory ("hot assets") at up to their inside basis, then other property | |
Example — current distribution: B's outside basis is $25,000. B receives $10,000 cash and land with an inside basis of $20,000 (fair value $30,000).
Cash reduces basis to $15,000 — no gain. The land's basis to B is limited to the remaining $15,000, and B's outside basis falls to zero.
Guaranteed payments
Payments for services or capital determined without regard to partnership income are ordinary income to the partner and generally deductible by the partnership. They are subject to self-employment tax when paid for services.
For planning angles, see tax planning for partnerships. Study the full topic in REG partnership taxation.