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Why this topic matters
Partnerships (and multi-member limited liability companies (LLCs) taxed as partnerships) are pure pass-through entities with flexible allocations — and the most complex basis rules on Taxation and Regulation (REG). Expect calculations of a partner's outside basis, the effect of liabilities, guaranteed payments, and the tax result of distributions.
Forming a partnership — Section 721
- Generally no gain or loss is recognized when property is contributed for a partnership interest — there is no control requirement (unlike Section 351 for corporations).
- Contributing services for a capital interest is taxable compensation at the interest's fair market value (FMV). A profits-only interest is generally not taxable on receipt.
- Partner's outside basis = cash + adjusted basis of property contributed + share of partnership liabilities − liabilities of the partner assumed by the partnership.
- Partnership's inside basis in contributed property = the partner's adjusted basis (carryover), and the holding period tacks.
- If net liability relief (a decrease in the partner's liabilities) exceeds the partner's basis, the excess is gain — treated as a deemed cash distribution.
EXAMPLE: A contributes property (basis $40,000, FMV $100,000) subject to a $30,000 mortgage to a partnership with three equal partners. The partnership assumes the mortgage.
A's basis = 40,000 − 30,000 (relief) + 10,000 (one-third share of the partnership's new liability) = $20,000. No gain, because the net relief ($20,000) doesn't exceed A's basis ($40,000). The partnership's basis in the property is $40,000.
Built-in gain — Section 704(c)
Pre-contribution gain or loss on contributed property is allocated to the contributing partner when the partnership recognizes it. Depreciation is also allocated to account for the difference between tax basis and FMV.
Operations
- The partnership files Form 1065 (due March 15 for calendar years) and issues Schedule K-1 to each partner; it pays no income tax.
- Ordinary business income and separately stated items (capital gains and losses, Section 1231 items, charitable contributions, dividends, interest, Section 179 expense, tax-exempt income, investment interest, foreign taxes) flow through.
- Partners are taxed on their distributive share whether or not it is distributed.
- Special allocations in the partnership agreement are respected if they have substantial economic effect; otherwise items are allocated by the partners' interests in the partnership.
- Required tax year: the tax year of partners owning a majority interest; then that of all principal (5% or more) partners; then the year resulting in the least aggregate deferral.
Guaranteed payments
- Payments to a partner for services or capital that are determined without regard to partnership income.
- Deductible by the partnership (reducing ordinary income) and ordinary income to the partner, included in the partner's tax year in which the partnership's year ends.
- Subject to self-employment tax (for services); not eligible for the qualified business income deduction.
EXAMPLE: Partnership income before guaranteed payments is $100,000; Partner A (30% share) receives a $20,000 guaranteed payment. Ordinary income = $80,000. A reports 20,000 + 30% × 80,000 = $44,000.
Self-employment tax
A general partner's distributive share of trade or business income and all guaranteed payments for services are subject to self-employment tax. A limited partner's share is generally exempt, except for guaranteed payments for services.
Outside basis — adjustments each year
| Increase | Decrease (not below zero) |
|---|---|
| Additional contributions | Distributions (cash and basis of property) |
| Share of taxable and tax-exempt income | Share of losses and deductions |
| Increase in share of partnership liabilities | Decrease in share of partnership liabilities (a deemed cash distribution) |
| Share of nondeductible expenses |
Losses are deductible only up to outside basis (then at-risk, passive, and excess business loss limits apply); excess losses carry forward. Recourse liabilities are shared by economic risk of loss; nonrecourse liabilities generally by profit shares.
Distributions
Current (nonliquidating) distributions
- Cash (including a decrease in liabilities and marketable securities) reduces basis; gain is recognized only if cash exceeds outside basis. No loss is recognized.
- Property: the partner takes the partnership's basis, limited to the partner's remaining outside basis (after cash). No gain or loss.
- Order: cash first, then unrealized receivables and inventory, then other property.
Liquidating distributions
- The partner's entire remaining outside basis is assigned to the property received (after cash, receivables, and inventory).
- Gain only if cash exceeds outside basis.
- Loss only if the distribution consists solely of cash, unrealized receivables, and inventory, and outside basis exceeds their total.
EXAMPLE: A partner with an outside basis of $50,000 receives, in liquidation, $10,000 cash and land with a partnership basis of $15,000. The land takes the remaining basis: 50,000 − 10,000 = $40,000. No gain or loss.
Selling a partnership interest
- Gain or loss = amount realized (cash + FMV of property + relief of the partner's share of liabilities) − outside basis.
- Generally capital, except the portion attributable to "hot assets" (Section 751 — unrealized receivables, including depreciation recapture, and inventory), which is ordinary.
- A Section 754 election lets the partnership adjust the inside basis of its assets for the buyer (and in certain distributions).
Administration
- Under the centralized partnership audit regime (from the Bipartisan Budget Act of 2015), audits happen at the partnership level, and any imputed underpayment is generally assessed against the partnership. A partnership representative has sole authority to act. Small partnerships (100 or fewer eligible partners) may elect out.
- Late filing penalties apply per partner, per month.
How it is tested
- Compute initial outside basis with contributed property and liabilities.
- Compute a partner's share of income including guaranteed payments.
- Adjust basis for income, losses, distributions, and liability changes.
- Determine gain, loss, and property basis on distributions.
EXAM TIP: Any decrease in a partner's share of partnership debt is treated as a cash distribution. If total cash (actual plus deemed) exceeds outside basis, the partner recognizes gain — even if no money changed hands.