Partnerships

Partnership taxation from formation to termination: contributions of property and services, inside and outside basis, the effect of liabilities, guaranteed payments, distributions, sales of an interest, related-party rules, family partnerships and the centralized audit regime. Outside basis computations are among the most common Part 2 calculation items.

Business Entities and Considerations5 min read7 sections

Must-know for the exam

Contributing property for a partnership interest is tax-free; outside basis equals the property's adjusted basis, and the partnership takes the same basis (IRC 721, 722, 723).
A capital interest received for services is ordinary income at its fair market value (Treas. Reg. 1.721-1(b)(1); IRC 83).
An increase in a partner's share of liabilities is a deemed cash contribution; a decrease is a deemed distribution (IRC 752(a)-(b)).
A partner deducts losses only up to outside basis at year end; the excess is suspended until basis returns (IRC 704(d)).
Guaranteed payments are ordinary income to the partner even in a loss year, deductible by the partnership, with no Form W-2 (IRC 707(c); Pub. 541 (12-2025)).
A current cash distribution produces gain only to the extent it exceeds outside basis; distributed property takes the smaller of inside basis or remaining outside basis (IRC 731, 732).
On a sale of an interest, the part attributable to unrealized receivables and inventory is ordinary income (IRC 751(a)).
Losses between a partnership and a partner owning over 50% are disallowed (IRC 707(b)(1)).
A partnership terminates only when no business continues to be carried on by any partners in a partnership; technical terminations ended after 2017 (IRC 708(b)(1)).
Partnerships with 100 or fewer eligible partners may elect out of the centralized audit regime on a timely return (IRC 6221(b); Form 1065 instructions (2025)).

On this page · 7 sections

Traps that cost marks

Using fair market value as the contributing partner's basis.
Treating services as property eligible for section 721.
Treating partners as employees who receive Form W-2.
Using the capital account instead of outside basis.
Ignoring liabilities in outside basis.
Treating the entire gain on a partnership interest as capital gain.
Confusing section 754 with other partnership elections.
Recognizing family partners in a business where income comes mainly from personal services.

Why it matters on the exam

Partnership questions reward a clean basis ledger. The SEE gives a partner's opening basis and a list of K-1 items, contributions, distributions and liability changes, then asks for ending basis, recognized gain or allowed loss. Learn the adjustments in order and the treatment of liabilities.

A partnership files Form 1065 but pays no income tax; partners report their distributive share whether or not it is distributed (IRC 701, 702).

Formation and contributions

•Property: no gain or loss. Land with a $30,000 basis and $50,000 value gives a $30,000 outside basis; the $20,000 built-in gain is allocated back to the contributor under IRC 704(c).
•Services: a capital interest is compensation income; a profits interest may qualify for the Rev. Proc. 93-27 safe harbor.
•Encumbered property: debt relief, net of the contributor's retained share, is a deemed distribution. A $40,000-basis building with a $60,000 mortgage for a 25% interest: relief of $45,000 exceeds $40,000 of basis, so $5,000 of gain and zero basis.

Premium

Every note. Every question. One pass.

5 more sections of this note are part of Premium.

Every section of every study note
750+ original questions across every outline topic
Full timed practice exams
A worked explanation on every question
Your full mistake bank and weak-area review

Unlock with Premium

From about US$12.42/mo on the Until-you-pass pass (12 months)

Exam-style questions

← Previous note: Business Entities, Classification and Elections All study notes

← All study notes

Business Entities and Considerations