Formation: Section 721
Generally no gain or loss is recognized when a partner contributes property in exchange for a partnership interest — with no control requirement (unlike §351 for corporations). Exceptions: contributing services (compensation income), and contributions where liability relief exceeds basis.
Partner basis — the outside basis formula
Initial basis = cash + adjusted basis of property contributed + share of partnership liabilities assumed.
Then adjust: + share of income and additional contributions and increases in liability share; − distributions, share of losses, decreases in liability share.
IMPORTANT: A partner's share of partnership liabilities is included in outside basis. An increase in a partner's liability share is treated as a deemed cash contribution; a decrease is a deemed cash distribution — which can trigger gain if it exceeds basis.
Guaranteed payments
Payments to a partner for services or use of capital, determined without regard to partnership income. They are deductible by the partnership (reducing ordinary income allocated to all partners) and are ordinary income to the recipient partner, subject to self-employment tax.
Distributions
| Type | Treatment |
|---|---|
| Current (non-liquidating) cash | Tax-free to the extent of basis; excess is capital gain |
| Current property | Carryover basis to the partner, limited to the partner's remaining outside basis; no gain generally recognized |
| Liquidating | Basis is fully allocated to distributed property; loss recognized only if the distribution is all cash, unrealized receivables, and inventory |
Hot assets (§751)
Unrealized receivables and substantially appreciated inventory produce ordinary income — even on the sale of a partnership interest that would otherwise generate capital gain. This prevents converting ordinary income into capital gain by selling the interest.
EXAM TIP: Losses are limited in three sequential hurdles: basis, then at-risk, then passive activity rules. Always apply them in that order.