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Why this topic matters
Partnerships and limited liability companies (LLCs) taxed as partnerships offer the most flexibility of any entity — special allocations, tax-free contributions and distributions, and basis from entity debt. Tax Compliance and Planning (TCP) tests compliance with Form 1065, the elections that shape partners' results, anti-abuse rules, and planning for contributions, distributions, and sales of interests.
Compliance
- Form 1065 is due March 15 (calendar year), with a 6-month extension. Each partner receives a Schedule K-1; partnerships with international items also provide Schedules K-2 and K-3.
- Partners' capital accounts must be reported on the tax basis on Schedule K-1.
- Late filing penalties apply per partner, per month.
- Centralized partnership audit regime (Bipartisan Budget Act of 2015): the partnership designates a partnership representative with sole authority; audit adjustments are generally assessed at the partnership level in the year the audit concludes (an imputed underpayment), unless the partnership elects to "push out" adjustments to the reviewed-year partners. Partnerships with 100 or fewer eligible partners (individuals, C and S corporations, estates) may elect out annually.
Key elections and methods
| Election or method | Effect |
|---|---|
| Section 754 election | Adjusts the partnership's inside basis on a transfer of an interest (Section 743(b) — for the buyer only) or a distribution (Section 734(b)), so a buyer's share of inside basis matches what they paid. Mandatory adjustments apply when there is a substantial built-in loss (over $250,000). |
| Section 704(c) methods for contributed property | Traditional (limited by the ceiling rule), traditional with curative allocations, or remedial — determine how built-in gain and depreciation are shared between the contributor and other partners |
| Special allocations | Respected if they have substantial economic effect — capital accounts maintained properly, liquidation according to capital accounts, and a deficit restoration obligation or qualified income offset |
| Tax year | Generally the majority-interest partners' tax year |
EXAMPLE: B buys A's one-third interest for $300,000 when A's share of the partnership's inside basis is $180,000 (assets have appreciated). Without a Section 754 election, B would be taxed on built-in gain when the partnership sells those assets. With the election, B gets a $120,000 Section 743(b) step-up that belongs only to B.
Anti-abuse rules to plan around
- Disguised sales: a contribution of property followed by a distribution of money to the contributing partner within 2 years is presumed to be a sale (with exceptions for guaranteed payments, preferred returns, and reimbursements of certain capital expenditures).
- Mixing bowl rules: if contributed property is distributed to another partner within 7 years, the contributing partner recognizes the remaining built-in gain (Section 704(c)(1)(B)). If the contributing partner receives other property within 7 years, they may recognize gain (Section 737).
- Hot assets: on a sale of an interest, the share of unrealized receivables and inventory (including depreciation recapture) produces ordinary income (Section 751).
- Carried interests: gain allocated to a service partner's "applicable partnership interest" in an investment fund needs a holding period of more than 3 years to be long-term (Section 1061).
- Family partnerships: capital must be a material income-producing factor, and a donor partner must be paid reasonable compensation for services before profits are allocated to family members.
Liabilities and loss planning
- A partner's outside basis includes their share of partnership liabilities — recourse debt by economic risk of loss; nonrecourse debt generally by profit shares (after minimum gain and Section 704(c) allocations).
- Loss limits apply in order: basis, at-risk (qualified nonrecourse real estate financing counts), passive activity, and excess business loss (made permanent by the One Big Beautiful Bill Act (OBBBA)).
- Planning: increase basis with contributions or guarantees (recourse debt allocation), or time losses with basis.
Self-employment tax and compensation
- General partners pay self-employment tax on their distributive share of trade or business income; limited partners generally do not, except on guaranteed payments for services. Courts have narrowed the limited partner exception to passive investors — active LLC members and state-law limited partners who work in the business may owe it.
- Guaranteed payments are deductible by the partnership, ordinary income to the partner, excluded from qualified business income, and subject to self-employment tax.
- Partners cannot be W-2 employees of their own partnership (except through certain tiered structures).
Distributions and exits
- Current distributions of cash beyond outside basis create gain; property distributions usually don't — but watch the mixing bowl rules and marketable securities treated as cash.
- Liquidating a partner: payments may be split between Section 736(b) payments for the partner's interest in partnership property (capital) and Section 736(a) payments (ordinary — guaranteed payments or distributive share), affecting both the partner and remaining partners.
- Selling an interest versus a redemption by the partnership produces different results for the buyer and the partnership (Section 754 adjustments differ).
- A partnership terminates only if no part of its business continues in partnership form (the old 50% "technical termination" rule was repealed).
How it is tested
- Apply Section 754 and 743(b) adjustments.
- Identify disguised sales and mixing bowl triggers.
- Allocate liabilities and test loss limitations.
- Plan guaranteed payments, self-employment tax, and exits.
EXAM TIP: Watch the clocks: 2 years for disguised sales, 7 years for mixing bowl rules, 3 years for carried interest long-term treatment.