ContentsIntroduction ........................................ 1

Forming a Partnership ....................... 2

Terminating a Partnership ................ 3

Exclusion From Partnership Rules .. 3

Tax Year .............................................. 4

Partnership Return (Form 1065) ....... 5

Penalties .............................................. 5

Partnership Income or Loss ............. 5

Partner's Distributive Share .............. 6

Partnership Distributions .................. 8

Transactions Between Partnershipand Partners ................................ 11

Basis of Partner's Interest ................ 13

Disposition of Partner's Interest ...... 15

Adjusting the Basis of PartnershipProperty ........................................ 18

Form 1065 Example ........................... 18

How To Get More Information .......... 27

Index .................................................... 27

IntroductionThis publication explains how the tax law ap-plies to partnerships and to partners. A part-nership does not pay tax on its income but“passes through” any profits or losses to itspartners. Partners must include partnershipitems on their tax returns.

For a discussion of business expenses apartnership can deduct, see Publication 535.Members of oil and gas partnerships shouldread about the deduction for depletion inchapter 13 of that publication.

Certain partnerships must have a taxmatters partner (TMP) who is also a generalpartner. For information on the rules for des-ignating a TMP, see the instructions forSchedule B of Form 1065 and TemporaryRegulations section 301.6231(a)(7)–1T.

Withholding on foreign partner or firm. Ifa partnership acquires a U.S. real propertyinterest from a foreign person or firm, thepartnership may have to withhold tax on theamount it pays for the property (includingcash, fair market value of other property, andany assumed liability). If a partnership hasincome effectively connected with a trade orbusiness in the United States, it must with-hold on the income allocable to its foreignpartners. A partnership may have to withholdtax on a foreign partner's distributive shareof fixed or determinable income not effectivelyconnected with a U.S. trade or business. Apartnership that fails to withhold may be heldliable for the tax, applicable penalties, andinterest. For more information, see Publica-tion 515, Withholding of Tax on NonresidentAliens and Foreign Corporations.

Departmentof theTreasury

InternalRevenueService

Publication 541Cat. No. 15071D

PartnershipsFor use in preparing

1997 Returns

Get forms and other information faster and easier by: COMPUTER• World Wide Web ➤ www.irs.ustreas.gov• FTP ➤ ftp.irs.ustreas.gov• IRIS at FedWorld ➤ (703) 321-8020 FAX• From your FAX machine, dial ➤ (703) 368-9694See How To Get More Information in this publication.

Important Changes for1997Businesses classified as partnerships.The rules you must use to determine whethera business is classified as a partnershipchanged for businesses formed after 1996.For more information, see Forming a Part-nership.

Recognition period for precontributiongain. For appreciated property contributedto a partnership after June 8, 1997, the periodin which a contributing partner must recognizeprecontribution gain is extended from 5 yearsto 7 years. For more information, see Part-ner's Gain or Loss under Partnership Distri-butions.

Allocated basis of distributed properties.For a distribution of partnership propertiesafter August 5, 1997, the method of allocatinga partner's basis in the partnership among theproperties received has been changed. Formore information, see Partner's Basis forDistributed Property under Partnership Distri-butions.

Sale of partnership interest. For a sale orexchange of a partnership interest after Au-gust 5, 1997, it is no longer necessary thatinventory be substantially appreciated beforeit generates ordinary income (rather thancapital gain). Under the new rule, the amountattributable to both inventory and unrealizedreceivables is treated as realized from thesale or exchange of property that is not acapital asset. For more information, see Pay-ments for Unrealized Receivables and Inven-tory Items under Disposition of Partner's In-terest.

Important Change for1998Closing of partnership's tax year with re-spect to deceased partner. For partnershiptax years beginning after 1997, the partner-ship's tax year closes with respect to a part-ner whose entire interest in the partnership isterminated, whether by death, sale or ex-change, or liquidation. Previously, the part-nership's tax year closed only with respect toa partner who sold, exchanged, or liquidatedhis or her entire interest in the partnership.For more information, see Distributive Sharein Year of Disposition under Disposition ofPartner's Interest.

Important RemindersUnresolved tax problems. The ProblemResolution Program (PRP), which is ad-ministered by the Taxpayer Advocate, is fortaxpayers who have been unable to resolvetheir problems with the IRS. If you have a taxproblem you cannot clear up through normalchannels, you can call the IRS at1–800–829–1040 for PRP assistance. If youprefer, you can write to the office that lastcontacted you (or your local district director)and ask for PRP assistance. If you have ac-

cess to TTY/TDD equipment, you can call1–800–829–4059 to obtain this assistance.

Although the PRP office cannot changethe tax law or a technical tax decision, it canclear up problems that resulted from previouscontacts and ensure your case is given acomplete and impartial review. For more in-formation, see Publication 1546, The ProblemResolution Program of the Internal RevenueService.

Comments on IRS enforcement actions.The Small Business and Agricultural Regula-tory Enforcement Ombudsman and 10 Re-gional Fairness Boards were established toreceive comments from small business aboutfederal agency enforcement actions. TheOmbudsman will annually evaluate theenforcement activities and rate each agency'sresponsiveness to small business. If you wishto comment on the enforcement actions of theIRS, call 1–888–734–3247.

Useful ItemsYou may want to see:

Publication

m 505 Tax Withholding and EstimatedTax

m 533 Self-Employment Tax

m 535 Business Expenses

m 537 Installment Sales

m 538 Accounting Periods and Methods

m 544 Sales and Other Dispositions ofAssets

m 551 Basis of Assets

m 925 Passive Activity and At-Risk Rules

m 946 How To Depreciate Property

Form (and Instructions)

m 1065 U.S. Partnership Return of In-come

m Schedule K–1 (Form 1065) Partner'sShare of Income, Credits, De-ductions, Etc.

m 8308 Report of a Sale or Exchange ofCertain Partnership Interests

m 8582 Passive Activity Loss Limitations

m 8736 Application for Automatic Exten-sion of Time To File U.S. Returnfor a Partnership, REMIC, or forCertain Trusts

m 8832 Entity Classification Election

See How To Get More Information nearthe end of this publication for informationabout getting these publications and forms.

Forming a PartnershipA partnership is the relationship between twoor more persons who join together to carryon a trade or business. Each person contrib-utes money, property, labor, or skill, and eachexpects to share in the profits and losses.“Person,” when used to describe a partner,means an individual, a corporation, a trust,an estate, or another partnership.

For federal income tax purposes, the term“partnership” includes a syndicate, group,pool, joint venture, or similar organization that

is carrying on a trade or business and is notclassified as a trust, estate, or corporation.

A joint undertaking merely to share ex-penses is not a partnership. Mere co-ownership of property maintained and leasedor rented is not a partnership. However, if theco-owners provide services to the tenants, apartnership exists.

Organizations formed after 1996. Anunincorporated organization (including a lim-ited liability company) formed after 1996 isclassified as a partnership if it:

1) Has not made an election to be classifiedas a corporation,

2) Has more than one member,

3) Is organized to carry on business,

4) Is formed in the United States,

5) Is not organized under a law that de-scribes it as a corporation, body corpo-rate, body politic, joint-stock company,or joint-stock association, and

6) Is not an insurance company, real estateinvestment trust, exempt organization,or a bank whose deposits are insuredunder the Federal Deposit Insurance Actor similar statute.

Many organizations that would meet thesecriteria except that they were formed outsidethe United States are also classified as part-nerships. See section 301.7701–2 of theProcedure and Administration Regulations fordetails.

An organization that would meet thesecriteria except that it has only one member isdisregarded for federal tax purposes. Instead,all income, deductions, credits, and lossesfrom the organization are reported on theowner's return.

Organizations formed before 1997. An or-ganization that was formed before 1997 gen-erally keeps the classification it had previ-ously, unless it elects to change itsclassification. However, an organization can-not keep its classification as a partnership ifit has only one member. To be treated asseparate from its owner, it must elect to beclassified as a corporation.

Changing an organization's classification.An organization that is classified as a part-nership (or that would be classified as apartnership except that it has only one mem-ber) generally can elect to be classified as acorporation. An organization previously clas-sified as a corporation but that can be classi-fied as a partnership can elect to change itsclassification to a partnership. To make theelection, the organization must file Form8832, Entity Classification Election.

Conversion of partnership into limited li-ability company (LLC). The conversion ofa partnership into an LLC classified as apartnership for federal tax purposes does notterminate the partnership. The conversion isnot a sale, exchange, or liquidation of anypartnership interest, the partnership's tax yeardoes not close, and the LLC can continue touse the partnership's taxpayer identificationnumber.

However, the conversion may changesome of the partners' bases in their partner-ship interests if the partnership has recourseliabilities that become nonrecourse liabilities.

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Because the partners share recourse andnonrecourse liabilities differently, their basesmust be adjusted to reflect the new sharingratios. If a decrease in a partner's share ofliabilities exceeds the partner's basis, he orshe must recognize gain on the excess. Formore information, see Effect of PartnershipLiabilities under Basis of Partner's Interest,later.

The same rules apply if an LLC classifiedas a partnership is converted into a partner-ship.

Family PartnershipMembers of a family can be partners. How-ever, family members (or any other person)will be recognized as partners only if one ofthe following requirements is met.

1) If capital is a material income-producingfactor, they acquired their capital interestin a bona fide transaction (even if by giftor purchase from another family mem-ber), actually own the partnership inter-est, and actually control the interest.

2) If capital is not a material income-producing factor, they must have joinedtogether in good faith to conduct a busi-ness. In addition, they must have agreedthat contributions of each entitle them toa share in the profits. Some capital orservice must be provided by each part-ner.

Capital is material. Capital is a materialincome-producing factor if a substantial partof the gross income of the business comesfrom the use of capital. Capital is ordinarilyan income-producing factor if the operationof the business requires substantial invento-ries or investments in plants, machinery, orequipment.

Capital is not material. In general, capitalis not a material income-producing factor ifthe income of the business consists princi-pally of fees, commissions, or other compen-sation for personal services performed bymembers or employees of the partnership.

Capital interest. A capital interest in a part-nership is an interest in its assets that is dis-tributable to the owner of the interest if:

1) He or she withdraws from the partner-ship, or

2) The partnership liquidates.

The mere right to share in earnings andprofits is not a capital interest in the partner-ship.

Gift of capital interest. If a family member(or any other person) receives a gift of acapital interest in a partnership in which cap-ital is a material income-producing factor, thedonee's distributive share of partnership in-come is limited. To figure the donee's share:

1) The partnership income must be re-duced by reasonable compensation forservices the donor renders to the part-nership, and

2) The donee-partner's share of the re-maining profits allocated to donatedcapital must not be proportionatelygreater than the donor's share attribut-able to the donor's capital.

Purchase. For purposes of determininga partner's distributive share, an interest pur-chased by one family member from anotherfamily member is considered a gift from theseller. The fair market value of the purchasedinterest is considered donated capital. For thispurpose, members of a family include onlyspouses, ancestors, and lineal descendants(or a trust for the primary benefit of thosepersons).

Example. A father sold 50% of his busi-ness to his son. The resulting partnership hada profit of $60,000. Capital is a materialincome-producing factor. The father per-formed services worth $24,000, which is rea-sonable compensation, and the son per-formed no services. The $24,000 must beallocated to the father as compensation. Ofthe remaining $36,000 of profit due to capital,at least 50%, or $18,000, must be allocatedto the father since he owns a 50% capital in-terest. The son's share of partnership profitcannot be more than $18,000.

Husband-wife partnership. If spouses carryon a business together and share in the pro-fits and losses, they may be partners whetheror not they have a formal partnership agree-ment. If so, they should report income or lossfrom the business on Form 1065. They shouldnot report the income on a Schedule C (Form1040) in the name of one spouse as a soleproprietor.

Each spouse should carry his or her shareof the partnership income or loss fromSchedule K–1 (Form 1065) to their joint orseparate Form(s) 1040. Each spouse shouldinclude his or her respective share of self-employment income on a separate ScheduleSE (Form 1040), Self-Employment Tax. Thisgenerally does not increase the total tax onthe return, but it does give each spouse creditfor social security earnings on which retire-ment benefits are based.

Partnership AgreementThe partnership agreement includes the ori-ginal agreement and any modifications. Themodifications must be agreed to by all part-ners or adopted in any other manner providedby the partnership agreement. The agree-ment or modifications can be oral or written.

Partners can modify the partnershipagreement for a particular tax year after theclose of the year but not later than the datefor filing the partnership return for that year.This filing date does not include any exten-sion of time.

If the partnership agreement or any mod-ification is silent on any matter, the provisionsof local law are treated as part of the agree-ment.

Terminating aPartnershipA partnership terminates when:

1) All of its operations are discontinued andno part of any business, financial opera-tion, or venture is continued by any of itspartners in a partnership or a limited li-ability company classified as a partner-ship, or

2) At least 50% of the total interest in part-nership capital and profits is sold or ex-

changed within a 12-month period, in-cluding a sale or exchange to anotherpartner.

See Regulations section 1.708–1(b)(1) formore information on the termination of apartnership. For special rules that apply to amerger, consolidation, or division of a part-nership, see Regulations section1.708–1(b)(2).

Date of termination. The partnership's taxyear ends on the date of termination. Forpurposes of (1) above, the date of terminationis the date the partnership completes thewinding up of its affairs. For purposes of (2)above, the date of termination is the date ofthe sale or exchange of a partnership interestthat, by itself or together with other sales orexchanges in the preceding 12 months,transfers an interest of 50% or more in bothcapital and profits.

Short period return. If a partnership is ter-minated before the end of the tax year, Form1065 must be filed for the short period, whichis the period from the beginning of the taxyear through the date of termination. The re-turn is due the 15th day of the fourth monthfollowing the date of termination. See Part-nership Return (Form 1065), later, for infor-mation about filing Form 1065.

Exclusion FromPartnership RulesCertain partnerships that do not actively con-duct a business can choose to be completelyor partially excluded from being treated aspartnerships for federal income tax purposesif all the partners agree and the partners cancompute their own taxable income withoutcomputing the partnership's taxable income.However, the partners are not exempt fromthe rule that limits a partner's distributiveshare of partnership loss. Nor are they ex-empt from the requirement of a businesspurpose for adopting a tax year for the part-nership that differs from its required tax year,discussed later.

Investing partnership. An investing part-nership can be excluded if the participants inthe joint purchase, retention, sale, or ex-change of investment property:

1) Own the property as co-owners,

2) Reserve the right separately to take ordispose of their shares of any propertyacquired or retained, and

3) Do not actively conduct business orirrevocably authorize some person act-ing in a representative capacity to pur-chase, sell, or exchange the investmentproperty. Each separate participant candelegate authority to purchase, sell, orexchange his or her share of the invest-ment property for the time being for hisor her account, but not for a period ofmore than a year.

Operating agreement partnership. An op-erating agreement partnership group can beexcluded if the participants in the joint pro-duction, extraction, or use of property:

1) Own the property as co-owners, eitherin fee or under lease or other form of

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contract granting exclusive operatingrights,

2) Reserve the right separately to take inkind or dispose of their shares of anyproperty produced, extracted, or used,and

3) Do not jointly sell services or the prop-erty produced or extracted. Each sepa-rate participant can delegate authority tosell his or her share of the propertyproduced or extracted for the time beingfor his or her account, but not for a pe-riod of time in excess of the minimumneeds of the industry, and in no event formore than one year. However, this doesnot apply to an unincorporated organ-ization one of whose principal purposesis cycling, manufacturing, or processingfor persons who are not members of theorganization.

Electing the exclusion. An eligible organ-ization that wishes to be excluded from thepartnership rules must make the election notlater than the time for filing the partnershipreturn for the first tax year for which exclusionis desired. See section 1.761–2(b) of the In-come Tax Regulations for the procedures tofollow.

Tax YearTaxable income is figured on the basis of atax year. A “tax year” is the accounting periodused for keeping records and reporting in-come and expenses.

Partnership. A partnership determines itstax year as if it were a taxpayer. However,there are limits on the year it can choose. Ingeneral, a partnership must use its requiredtax year. Exceptions to this rule are discussedunder Exceptions to Required Tax Year, later.

Partners. Partners can change their tax yearonly if they receive permission from the IRS.This also applies to corporate partners whoare usually allowed to change their account-ing periods without prior approval if they meetcertain conditions.

Closing of tax year. Generally, the partner-ship's tax year is not closed because of thesale, exchange, or liquidation of a partner'sinterest, the death of a partner, or the entryof a new partner. However, if a partner sells,exchanges, or liquidates his or her entire in-terest, the partnership's tax year is closed forthat partner. See Distributive Share in Yearof Disposition under Disposition of Partner'sInterest, later.

Required Tax YearA partnership generally must conform its taxyear to its partners' tax years as follows:

1) Majority interest tax year. If one ormore partners having the same tax yearown an interest in partnership profits andcapital of more than 50% (a majority in-terest), the partnership must use the taxyear of those partners.

Testing day. The partnership deter-mines if there is a majority interest taxyear on the testing day, which is usuallythe first day of the partnership's currenttax year.

Change in tax year. If a partnership'smajority interest tax year changes, it willnot be required to change to another taxyear for 2 years following the year ofchange.

2) Principal partner. If there is no majorityinterest tax year, the partnership mustuse the tax year of all its principal part-ners. A principal partner is one who hasa 5% or more interest in the profits orcapital of the partnership.

3) Least aggregate deferral of income. Ifthere is no majority interest tax year andthe principal partners do not have thesame tax year, the partnership generallymust use a tax year that results in theleast aggregate deferral of income to thepartners.

Least aggregate deferral of income. Thetax year that results in the least aggregatedeferral of income is determined as follows:

1) Determine the number of months ofdeferral for each partner using one part-ner's tax year. Find the months ofdeferral by counting the months from theend of that tax year forward to the endof each other partner's tax year.

2) Multiply each partner's months of defer-ral determined in step (1) by that part-ner's share of interest in the partnershipprofits for the tax year used in step (1).

3) Add the amounts in step (2) to get theaggregate (total) deferral for the tax yearused in step (1).

4) Repeat steps (1) through (3) for eachpartner's tax year that is different fromthe other partners' years.

The partner's tax year that results in thelowest number in step (3) above is the taxyear that must be used by the partnership. Ifmore than one year qualifies as the tax yearthat has the least aggregate deferral of in-come, the partnership can choose any yearthat qualifies. However, if one of the yearsthat qualifies is the partnership's existing taxyear, the partnership must retain that taxyear.

Special de minimis rule. If the tax yearthat results in the least aggregate deferralproduces an aggregate deferral that is lessthan 0.5 when compared to the aggregatedeferral of the current tax year, the partner-ship's current tax year is treated as the taxyear with the least aggregate deferral.

Example. Rose and Irene each have a50% interest in a partnership that uses a fiscalyear ending June 30. Rose uses a calendaryear while Irene has a fiscal year ending No-vember 30. The partnership must change itstax year to a fiscal year ending November 30because this results in the least aggregatedeferral of income to the partners. This wasdetermined as shown in the following table.

Procedures. Generally, determination of thepartnership's required tax year is made at thebeginning of the partnership's current taxyear. However, the IRS can require the part-nership to use another day or period that willmore accurately reflect the ownership of thepartnership.

The change to a required tax year istreated as initiated by the partnership with theconsent of the IRS. No formal application fora change in tax year is needed.

Notifying IRS. Any partnership thatchanges to a required tax year must notify theIRS by writing at the top of the first page ofits tax return for its first required tax year,“FILED UNDER SECTION 806 OF THE TAXREFORM ACT OF 1986.”

Short period return. When a partnershipchanges its tax year, a short period returnmust be filed. The short period return coversthe months between the end of the partner-ship's prior tax year and the beginning of itsnew tax year.

If a partnership changes to the tax yearresulting in the least aggregate deferral of in-come, a statement must be attached to theshort period return showing the computationsused to determined that tax year. The shortperiod return must indicate at the top of page1, “FILED UNDER SECTION 1.706–1T.”

Exceptions to RequiredTax YearThere are two exceptions to the required taxyear rule.

Business purpose tax year. If a partnershipestablishes an acceptable business purposefor having a tax year different from its requiredtax year, the different tax year can be used.The deferral of income to the partners is notconsidered a business purpose.

See Business Purpose Tax Year in Publi-cation 538 for more information.

Section 444 election. Partnerships can electunder section 444 of the Internal RevenueCode to use a tax year different from both therequired tax year and any business purposetax year. Certain restrictions apply to thiselection. In addition, the electing partnershipmay be required to make a payment repre-senting the value of the extra tax deferral tothe partners.

See Section 444 Election in Publication538 for more information.

Months InterestYear End Year Profits of ×12/31: End Interest Deferral Deferral

Rose .................... 12/31 0.5 -0- -0-Irene ..................... 11/30 0.5 11 5.5

Total Deferral ......................................... 5.5

Months InterestYear End Year Profits of ×11/30: End Interest Deferral Deferral

Rose .................... 12/31 0.5 1 0.5Irene ..................... 11/30 0.5 -0- -0-

Total Deferral ......................................... 0.5

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Partnership Return(Form 1065)Each partnership engaged in a trade or busi-ness must file a return on Form 1065 showingits income, deductions, and other requiredinformation. In addition, the partnership returnshows the names and addresses of eachpartner and each partner's distributive shareof taxable income. This is an information re-turn and must be signed by a general partner.If a limited liability company is treated as apartnership, it must file Form 1065 and oneof its members must sign the return.

The first return of the partnership is notrequired to be filed until the first tax year thepartnership has income or deductions. Thepartnership is not required to file Form 1065for any tax year it receives no income and hasno expenses. It is not considered to be en-gaged in a trade or business that year. Seethe instructions for Form 1065 for more infor-mation.

Due date. Form 1065 generally must be filedby April 15 following the close of the partner-ship's tax year if its accounting period is thecalendar year. A fiscal year partnership gen-erally must file its return by the 15th day of the4th month following the close of its fiscal year.

If a partnership needs more time to file itsreturn, it should file Form 8736 by the regulardue date of its Form 1065. The automaticextension is 3 months.

If the partnership has made a section 444election to use a tax year other than a re-quired year, an automatic extension of timefor filing a return will run concurrently with anyextension of time allowed by the section 444election. The filing of an application for ex-tension does not extend the time for makingthe payment of any tax due on a partner'spersonal income tax return, nor does it extendthe time for filing a partner's personal incometax return.

If the date for filing a return or making atax payment falls on a Saturday, Sunday, orlegal holiday, the partnership can file the re-turn or make the payment on the next busi-ness day.

Schedule K–1 due to partners. The part-nership must furnish copies of Schedule K–1(Form 1065) to the partners by the date Form1065 is required to be filed, including exten-sions.

PenaltiesTo help ensure that returns are filed correctlyand on time, the law provides penalties forfailure to do so.

Failure to file. A penalty is assessed againstany partnership that must file a partnershipreturn and fails to file on time, including ex-tensions, or fails to file a return with all theinformation required. The penalty is $50 timesthe total number of partners in the partnershipduring any part of the tax year for each month(or part of a month) the return is late or in-complete, up to 5 months.

The penalty will not be imposed if thepartnership can show reasonable cause forits failure to file a complete or timely return.

Certain small partnerships (with 10 or fewerpartners) meet this reasonable cause test if:

1) All partners are individuals (other thannonresident aliens), estates, or C corpo-rations,

2) All partners have timely filed income taxreturns fully reporting their shares of thepartnership's income, deductions, andcredits, and

3) The partnership has not elected to besubject to the rules for consolidated auditproceedings (explained later under Part-ner's Distributive Share, in the dis-cussion Reporting Distributive Share).

CAUTION!

For partnership tax years ending be-fore August 6, 1997, a small partner-ship met this reasonable cause test

if:

1) All partners were individuals (other thannonresident aliens) or estates,

2) The partnership did not make a specialallocation of any partnership item, and

3) The requirements in (2) and (3) abovewere met.

The failure to file penalty is assessedagainst the partnership. However, each part-ner is individually liable for the penalty to theextent the partner is liable for partnershipdebts in general.

If the partnership wants to contest thepenalty, it must pay the penalty and sue forrefund in a U.S. District Court or the U.S.Court of Federal Claims.

Failure to furnish copies to the partners.The partnership must furnish copies ofSchedule K–1 to the partners. A penalty foreach statement not furnished will be as-sessed against the partnership unless thefailure to do so is due to reasonable causeand not willful neglect.

Trust fund recovery penalty. A person re-sponsible for withholding, accounting for, ordepositing or paying withholding taxes whowillfully fails to do so can be held liable for apenalty equal to the tax not paid, plus interest.

“Willfully” in this case means voluntarily,consciously, and intentionally. Paying otherexpenses of the business instead of the taxesdue is considered willful behavior.

A responsible person can be an officer ofa corporation, a partner, a sole proprietor, oran employee of any form of business. Thismay include a trustee or agent with authorityover the funds of the business.

Other penalties. Criminal penalties can beimposed for willful failure to file, tax evasion,or making a false statement.

Other penalties include those for:

1) Not supplying a taxpayer identificationnumber.

2) Not furnishing information returns.

3) Overstating tax deposit claims.

4) Underpaying tax due to a valuation mis-statement.

5) Not furnishing information on tax shel-ters.

6) Promoting abusive tax shelters.

However, certain penalties may not beimposed if there is reasonable cause fornoncompliance.

Partnership Incomeor Loss A partnership computes its income and filesits return in the same manner as an individual.However, certain deductions are not allowedto the partnership.

Separately stated items. Certain items mustbe separately stated on the partnership returnand included as separate items on the part-ners' returns. These items, listed on ScheduleK (Form 1065), are:

1) Ordinary income or loss from trade orbusiness activities.

2) Net income or loss from rental real es-tate activities.

3) Net income or loss from other real estateactivities.

4) Gains and losses from sales or ex-changes of capital assets.

5) Gains and losses from sales or ex-changes of section 1231 property.

6) Charitable contributions.

7) Dividends (passed through to corporatepartners) that qualify for the dividends-received deduction.

8) Taxes paid or accrued to foreign coun-tries and U.S. possessions.

9) Other items of income, gain, loss, de-duction, or credit, as provided by regu-lations. Examples include nonbusinessexpenses, intangible drilling and devel-opment costs, and soil and water con-servation expenses.

Elections. The partnership makes mostchoices about how to compute income. Theseinclude choices for:

1) Accounting methods.

2) Depreciation methods.

3) Accounting for specific items, such asdepletion or installment sales.

4) Nonrecognition of gain on involuntaryconversions of property.

5) Amortization of certain organization feesand business start-up costs of the part-nership.

However, each partner chooses how totreat the partner's share of foreign and U.S.possessions taxes, certain mining explorationexpenses, and income from cancellation ofdebt.

More information. For more informationon the following topics, see the listed publi-cation.

1) Accounting methods: Publication 538.

2) Depreciation methods: Publication 946.

3) Installment sales: Publication 537.

4) Amortization and depletion: Publication535, chapters 12 and 13.

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5) Involuntary conversions: Publication 544(condemnations) and Publication 547(casualties and thefts).

Organization expenses and syndicationfees. Neither the partnership nor any partnercan deduct, as a current expense, amountspaid or incurred to organize a partnership orto promote the sale of, or to sell, an interestin the partnership.

The partnership can choose to amortizecertain organization expenses over a periodof not less than 60 months. The period muststart with the month the partnership beginsbusiness. This election is irrevocable and theperiod the partnership chooses in this electioncannot be changed. If the partnership electsto amortize these expenses and is liquidatedbefore the end of the amortization period, theremaining balance in this account may bedeductible as a loss.

Making the election. The election toamortize organization expenses is made byattaching a statement to the partnership's re-turn for the tax year the partnership begins itsbusiness. The statement must provide all thefollowing information:

1) A description of each organization ex-pense incurred (whether or not paid).

2) The amount of each expense.

3) The date each expense was incurred.

4) The month the partnership began itsbusiness.

5) The number of months (not less than 60)over which the expenses are to beamortized.

A cash basis taxpayer must also indicatethe amount paid before the end of the yearfor each expense. Expenses less than $10need not be separately listed, provided thetotal amount is listed with the dates on whichthe first and last of the expenses were in-curred.

Amortizable expenses. Amortizationapplies to expenses that are:

1) Incident to the creation of the partner-ship,

2) Chargeable to a capital account, and

3) The type that would be amortized if theywere incurred in the creation of a part-nership having a fixed life.

To satisfy (1) and (2) above, an expensemust be incurred during the period beginningat a point which is a reasonable time beforethe partnership begins business and endingwith the date for filing the partnership return(not including extensions) for the tax year inwhich the partnership begins business. Inaddition, the expense must be for creating thepartnership and not for starting or operatingthe partnership trade or business.

To satisfy (3) above, the expense mustbe for a type of item normally expected tobenefit the partnership throughout its entirelife.

Organization expenses that can be amor-tized include:

1) Legal fees for services incident to theorganization of the partnership, such asnegotiation and preparation of a part-nership agreement.

2) Accounting fees for services incident tothe organization of the partnership.

3) Filing fees.

Expenses not amortizable. Expensesthat cannot be amortized (regardless of howthe partnership characterizes them) includeexpenses connected with:

1) Acquiring assets for the partnership ortransferring assets to the partnership.

2) Admitting or removing partners otherthan at the time the partnership is firstorganized.

3) Making a contract relating to the opera-tion of the partnership trade or business(even if the contract is between thepartnership and one of its members).

4) Syndicating the partnership. Syndicationexpenses, such as commissions, pro-fessional fees, and printing costs con-nected with the issuing and marketingof interests in the partnership, are capi-talized. They can never be deducted bythe partnership, even if the syndicationis unsuccessful.

Partner's DistributiveShare A partner's taxable income for a tax year in-cludes his or her distributive share of certainpartnership items for the partnership's taxyear ending with or within the partner's taxyear.

Partnership agreement. Generally, thepartnership agreement determines a partner'sdistributive share of any item or class of itemsof income, gain, loss, deduction, or credit.The allocations provided for in the partnershipagreement or any modification will be disre-garded if they do not have substantial eco-nomic effect. If an allocation does not havesubstantial economic effect or the partnershipagreement does not provide for the allocation,the partner's distributive share of the part-nership items is determined by the partner'sinterest in the partnership.

Substantial economic effect. An allo-cation has substantial economic effect if bothof the following apply:

1) There is a reasonable possibility that theallocation will substantially affect thedollar amount of the partners' shares ofpartnership income or loss independ-ently of tax consequences.

2) The partner to whom the allocation ismade actually receives the economicbenefit or bears the economic burdencorresponding to that allocation.

Nonrecourse liability. A nonrecourse liabilityis one for which no partner or related personhas an economic risk of loss. An allocationof a loss, deduction, or partnership expenseattributable to nonrecourse liabilities notdeductible or chargeable to capital cannothave economic effect. A partner's share ofnonrecourse deductions is determined by hisor her interest in the partnership. For the ruleson allocating nonrecourse deductions, seesection 1.704–2 of the Income Tax Regu-lations.

Partner's interest in partnership. If a part-ner's distributive share of a partnership itemcannot be determined under the partnershipagreement, it is determined by his or her in-terest in the partnership. The partner's inter-est is determined by taking all of the followinginto account.

1) The partner's contributions to the part-nership.

2) The interests of all partners in economicprofits and losses (if different from inter-ests in taxable income or loss) and incash flow and other nonliquidating dis-tributions.

3) The rights of the partners to distributionsof capital upon liquidation.

Gross income. When it is necessary to de-termine the gross income of a partner, thepartner's gross income includes his or herdistributive share of the partnership's grossincome. For example, the partner's share ofthe partnership gross income is used in de-termining whether an income tax return mustbe filed by that partner.

Estimated tax. Partners may have to makepayments of estimated tax as a result ofpartnership income.

Generally, the required estimated taxpayment for individuals is the smaller of:

1) 90% of the tax to be shown on the cur-rent year's tax return, or

2) 100% of the total tax shown on the prioryear's tax return.

A different rule applies to individuals whoreceive at least two-thirds of their gross in-come from farming or fishing.

See Publication 505 for more information.

Self-employment tax. A partner is not anemployee of the partnership. The partner'sdistributive share of ordinary income from apartnership is generally included in figuringnet earnings from self-employment. However,a limited partner generally does not includehis or her distributive share of income or lossin computing net earnings from self-employment. This exclusion does not applyto guaranteed payments made to a limitedpartner for services actually rendered to oron behalf of a partnership engaged in a tradeor business. If an individual partner has netearnings from self-employment of $400 ormore for the year, the partner must figureself-employment tax on Schedule SE (Form1040). For more information on self-employment tax, see Publication 533.

Alternative minimum tax. To figure alter-native minimum tax, a partner must sepa-rately take into account any distributive shareof items of income and deductions that enterinto the computation of alternative minimumtaxable income. For information on whichitems of income and deductions are affected,see the Form 6251 instructions.

Reporting DistributiveShare A partner must report his or her distributiveshare of partnership items on his or her taxreturn, whether or not it is actually distributed.However, a partner's distributive share of aloss may be limited. See Limits on Losses,later. These items are reported to the partner

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on Schedule K–1 (Form 1065). See the Part-ner's Instructions for Schedule K–1 (Form1065) for more information.

To determine the allowable amount of anydeduction or exclusion subject to a limit, apartner must combine any separate de-ductions or exclusions on his or her incometax return with the distributive share of part-nership deductions or exclusions before ap-plying the limit.

Character of items. The character of eachitem of income, gain, loss, deduction, or creditincluded in a partner's distributive share isdetermined as if the partner:

1) Realized the item directly from the samesource as the partnership, or

2) Incurred the item in the same manneras the partnership.

For example, a partner's distributive shareof gain from the sale of partnership depre-ciable property used in the trade or businessof the partnership is treated as gain from thesale of depreciable property the partner usedin a trade or business.

Inconsistent treatment of items. Partnersmust generally treat partnership items thesame way on their individual tax returns asthey are treated on the partnership return. Ifa partner treats an item differently on his orher individual return, the IRS can immediatelyassess and collect any tax and penalties thatresult from adjusting the item to make it con-sistent with the partnership return. However,this rule will not apply if a partner identifies thedifferent treatment by filing Form 8082, No-tice of Inconsistent Treatment or Administra-tive Adjustment Request (AAR), with his orher return.

Consolidated audit procedures. Undercurrent examination procedures, the taxtreatment of any partnership item is deter-mined at the partnership level in a consol-idated audit proceeding, rather than at theindividual partner's level. After the propertreatment is determined at the partnershiplevel, the IRS can automatically make relatedadjustments to the tax returns of the partners,based on their share of the adjusted items.

The consolidated audit procedures do notapply to certain small partnerships (with 10or fewer partners) if each partner is either:

1) An individual (other than a nonresidentalien),

2) A C corporation, or

3) An estate of a deceased partner.

However, small partnerships can make anelection to have these procedures apply.

CAUTION!

For partnership tax years ending be-fore August 6, 1997, these proce-dures do not apply to small partner-

ships if both of the following applied:

1) Each partner was an individual (otherthan a nonresident alien) or an estate.

2) The partnership did not make a specialallocation of any partnership item.

Limits on Losses

Partner's adjusted basis. A partner's dis-tributive share of partnership loss is allowedonly to the extent of the adjusted basis of thepartner's partnership interest. The adjustedbasis is figured at the end of the partnership'stax year in which the loss occurred, beforetaking the loss into account. Any loss morethan the partner's adjusted basis is notdeductible for that year. However, any lossnot allowed for this reason will be allowed asa deduction (up to the partner's basis) at theend of any succeeding year in which thepartner increases his or her basis to morethan zero. See Basis of Partner's Interest,later.

Example. Mike and Joe are equal part-ners in a partnership. Mike files his individualreturn on a calendar year basis. The partner-ship return is also filed on a calendar yearbasis. The partnership incurred a $10,000loss last year and Mike's distributive share ofthe loss is $5,000. The adjusted basis of hispartnership interest before considering hisshare of last year's loss was $2,000. He couldclaim only $2,000 of the loss on last year'sindividual return. The adjusted basis of hisinterest at the end of last year was then re-duced to zero.

The partnership showed an $8,000 profitfor this year. Mike's $4,000 share of the profitincreased the adjusted basis of his interestby $4,000 (not taking into account the $3,000excess loss he could not deduct last year).His return for this year will show his $4,000distributive share of this year's profits and the$3,000 loss not allowable last year. The ad-justed basis of his partnership interest at theend of this year is $1,000.

Not-for-profit activity. Deductions relatingto an activity not engaged in for profit arelimited. For a discussion of the limits, seechapter 1 in Publication 535.

At-risk limits. At-risk rules apply to mosttrade or business activities, including activ-ities conducted through a partnership. Theat-risk rules limit a partner's deductible lossto the amounts for which that partner is con-sidered at risk in the activity.

A partner is considered at risk for:

1) The money and adjusted basis of anyproperty he or she contributed to theactivity.

2) The partner's share of net income re-tained by the partnership.

3) Certain amounts borrowed by the part-nership for use in the activity if the part-ner is personally liable for repayment orthe amounts borrowed are secured bythe partner's property (other than prop-erty used in the activity).

A partner is not considered at risk foramounts protected against loss throughguarantees, stop-loss agreements, or similararrangements. Nor is the partner at risk foramounts borrowed if the lender has an inter-est in the activity (other than as a creditor)or is related to a person (other than the part-ner) having such an interest.

For more information on determining theamount at risk, see Publication 925.

Passive activities. Generally, section 469of the Internal Revenue Code limits theamount a partner can deduct for passive ac-tivity losses and credits. The passive activitylimits do not apply to the partnership. Instead,they apply to each partner's share of loss orcredit from passive activities. Because thetreatment of each partner's share of partner-ship income, loss, or credit depends on thenature of the activity that generated it, thepartnership must report income, loss, andcredits separately for each activity.

Generally, passive activities include atrade or business activity in which the partnerdoes not materially participate. The level ofeach partner's participation must be deter-mined by the partner.

Rental activities. Passive activities alsoinclude rental activities, regardless of thepartner's participation. However, a rental realestate activity in which the partner materiallyparticipates is not considered a passive ac-tivity. The partner must also meet both of thefollowing conditions for the tax year:

1) More than half of the personal servicesthe partner performs in any trade orbusiness are in a real property trade orbusiness in which the partner materiallyparticipates.

2) The partner performs more than 750hours of service in real property tradesor businesses in which the partnermaterially participates.

Limited partners. Limited partners aregenerally not considered to materially partic-ipate in trade or business activities conductedthrough partnerships.

More information. For more informationon passive activities, see Publication 925 andthe instructions to Forms 1065 and 8582.

Partner's Exclusions andDeductionsCancellation of qualified real propertybusiness debt. A partner other than a Ccorporation can elect to exclude from grossincome the partner's distributive share of in-come from cancellation of the partnership'squalified real property business debt. This isa debt (other than a qualified farm debt) in-curred or assumed by the partnership inconnection with real property used in its tradeor business and secured by that property. Adebt incurred or assumed after 1992 qualifiesonly if it was incurred or assumed to acquire,construct, reconstruct, or substantially im-prove such property. A debt incurred to refi-nance a qualified real property business debtqualifies, but only up to the refinanced debt.

A partner who elects the exclusion mustreduce the basis of his or her depreciable realproperty by the amount excluded. For thispurpose, a partnership interest is treated asdepreciable real property to the extent of thepartner's share of the partnership's deprecia-ble real property. However, a partnership in-terest cannot be treated as depreciable realproperty unless the partnership makes a cor-responding reduction in the basis of itsdepreciable real property with respect to thatpartner.

To elect the exclusion, the partner mustfile Form 982 with his or her original incometax return. If the election is not made on thatreturn, a partner may request permission tomake a late election, but must show that heor she acted reasonably and in good faith and

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that granting relief will not prejudice the in-terests of the government. For more informa-tion on making a late election, see sections301.9100–1T through 301.9100–3T of theTemporary Procedure and AdministrationRegulations.

Exclusion limit. The partner's exclusioncannot be more than the smaller of the fol-lowing two amounts.

1) The partner's share of the excess (if any)of:

a) The outstanding principal of thedebt immediately before the can-cellation, over

b) The fair market value (as of thattime) of the property securing thedebt, reduced by the outstandingprincipal of other qualified realproperty business debt secured bythat property (as of that time).

2) The total adjusted bases of depreciablereal property held by the partner imme-diately before the cancellation (otherthan property acquired in contemplationof the cancellation).

Effect on partner's basis. Because ofoffsetting adjustments, the cancellation of apartnership debt does not usually cause a netchange in the basis of a partnership interest.Each partner's basis is:

1) Increased by his or her share of thepartnership income from the cancellationof debt (whether or not the partner ex-cludes the income), and

2) Reduced by the deemed distribution re-sulting from the reduction in his or hershare of partnership liabilities.

(See Adjusted Basis under Basis of Partner'sInterest, later.) The basis of a partner's inter-est will change only if the partner's share ofincome is different from the partner's shareof debt.

As explained earlier, however, a partner'selection to exclude income from the cancel-lation of debt may reduce the basis of thepartner's interest to the extent the interest istreated as depreciable real property.

Basis of depreciable real property re-duced. If the basis of depreciable real prop-erty is reduced, and the property is disposedof, then for purposes of determining recaptureunder section 1250 of the Internal RevenueCode:

1) Any such basis reduction is treated as adeduction allowed for depreciation, and

2) The determination of what would havebeen the depreciation adjustment underthe straight line method is made as ifthere had been no such reduction.

Therefore, the basis reduction recapturedas ordinary income is reduced over the timethe partnership continues to hold the property,as the partnership forgoes depreciation de-ductions due to the basis reduction.

More information. See chapter 5 inPublication 334 for more information onqualified real property business debt.

Section 179 deduction. A partner can electto deduct all or part of the cost of certain as-sets under section 179 of the Internal Reve-nue Code.

Limits. The section 179 deduction issubject to certain limits that apply to thepartnership and to each partner. The part-nership determines its section 179 deductionsubject to the limits. It then allocates the de-duction among its partners.

Each partner adds the amount allocatedfrom the partnership (shown on ScheduleK–1) to his or her other nonpartnership sec-tion 179 costs and then applies the maximumdollar limit to this total. To determine if apartner has exceeded the $200,000 invest-ment limit, the partner does not include anyof the cost of section 179 property placed inservice by the partnership. After the maximumdollar limit and investment limit are applied,the remaining cost of the partnership andnonpartnership section 179 property is sub-ject to the taxable income limit.

Figuring partnership's taxable income.For purposes of the taxable income limit,taxable income of a partnership is figured byadding together the net income (or loss) fromall trades or businesses actively conductedby the partnership during the tax year.

Figuring partner's taxable income. Forpurposes of the taxable income limit, the tax-able income of a partner who is engaged inthe active conduct of one or more of a part-nership's trades or businesses includes hisor her allocable share of taxable income de-rived from the partnership's active conduct ofany trade or business.

Basis adjustment. A partner who is al-located section 179 expenses from the part-nership must reduce the basis of his or herpartnership interest by the total section 179expenses allocated, regardless of whetherthe full amount allocated can be currentlydeducted. See Adjusted Basis under Basisof Partner's Interest, later. If a partner dis-poses of his or her interest in a partnership,the partner's basis for determining gain orloss is increased by any outstanding carry-over of disallowed deductions of section 179expenses allocated from the partnership.

The basis of a partnership's section 179property must be reduced by the section 179deduction elected by the partnership. Thisreduction of basis must be made even if anypartner cannot deduct his or her entireallocable share of the section 179 deductionbecause of the limits.

More information. See Publication 946for more information on the section 179 de-duction.

Partnership expenses paid by partner. Ingeneral, a partner cannot deduct partnershipexpenses paid out of personal funds unlessthe partnership agreement requires the part-ner to pay the expenses. These expenses areusually considered incurred and deductibleby the partnership.

If an employee of the partnership performspart of a partner's duties and the partnershipagreement requires the partner to pay theemployee out of personal funds, the partnercan deduct the payment as a business ex-pense.

Interest expense for distributed loan. If thepartnership distributes borrowed funds to apartner, the partnership should list the part-ner's share of interest expense for thesefunds as “Interest expense allocated to debt-financed distributions” under “Other de-ductions” on the partner's Schedule K–1. Thepartner deducts this interest on his or her taxreturn depending on how the partner uses the

funds. See chapter 8 in Publication 535 formore information on the allocation of interestexpense related to debt-financed distribu-tions.

Debt-financed acquisitions. The interestexpense on loan proceeds used to purchasean interest in, or make a contribution to, apartnership must be allocated as explained inchapter 8 of Publication 535.

PartnershipDistributions Partnership distributions include the following:

1) A withdrawal by a partner in anticipationof the current year's earnings.

2) A distribution of the current year's orprior years' earnings not needed forworking capital.

3) A complete or partial liquidation of apartner's interest.

4) A distribution to all partners in a com-plete liquidation of the partnership.

A partnership distribution is not taken intoaccount in determining the partner's distribu-tive share of partnership income or loss. If anygain or loss from the distribution is recognizedby the partner, it must be reported on his orher return for the tax year in which the distri-bution is received. Money or property with-drawn by a partner in anticipation of the cur-rent year's earnings is treated as a distributionreceived on the last day of the partnership'stax year.

Effect on partner's basis. A partner's ad-justed basis in his or her partnership interestis decreased (but not below zero) by themoney and adjusted basis of property dis-tributed to the partner. See Adjusted Basisunder Basis of Partner's Interest, later.

Effect on partnership. A partnership gen-erally does not recognize any gain or lossbecause of distributions it makes to partners.The partnership may be able to elect to adjustthe basis of its undistributed property, as ex-plained later under Adjusting the Basis ofPartnership Property.

Certain distributions treated as a sale orexchange. When a partnership distributesthe following items, the distribution may betreated as a sale or exchange of propertyrather than a distribution.

1) Unrealized receivables or substantiallyappreciated inventory items to a partnerin exchange for any part of the partner'sinterest in other partnership property, in-cluding money.

2) Other property (including money) in ex-change for any part of a partner's interestin unrealized receivables or substantiallyappreciated inventory items.

See Payments for Unrealized Receivablesand Inventory Items under Disposition ofPartner's Interest, later.

This treatment does not apply in the fol-lowing situations:

1) A distribution of property to the partnerwho contributed the property to thepartnership.

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2) Certain payments made to a retiringpartner or successor in interest of a de-ceased partner.

Partner's Gain or Loss A partner generally recognizes gain on apartnership distribution only to the extent anymoney (and marketable securities treated asmoney) included in the distribution exceedsthe adjusted basis of the partner's interest inthe partnership. Any gain recognized is gen-erally treated as capital gain from the sale ofthe partnership interest on the date of thedistribution. If partnership property (other thanmarketable securities treated as money) isdistributed to a partner, he or she generallydoes not recognize any gain until the sale orother disposition of the property.

For exceptions to these rules, see Distri-bution of partner's debt and following dis-cussions, later. Also, see Payments for Un-realized Receivables and Inventory Itemsunder Disposition of Partner's Interest, later.

Example. The adjusted basis of Jo'spartnership interest is $14,000. She receivesa distribution of $8,000 cash and land that hasan adjusted basis of $2,000 and a fair marketvalue of $3,000. Because the cash receiveddoes not exceed the basis of her partnershipinterest, Jo does not recognize any incomeon the distribution. Any gain on the land willbe recognized when she sells or otherwisedisposes of it. The distribution decreases theadjusted basis of Jo's partnership interest to$4,000 [$14,000 − ($8,000 + $2,000)].

Marketable securities treated as money. Generally, a marketable security distributedto a partner after December 8, 1994, istreated as money in determining whether gainis recognized on the distribution. This treat-ment, however, does not generally apply ifthat partner contributed the security to thepartnership or an investment partnershipmade the distribution to an eligible partner.

The amount treated as money is the se-curity's fair market value when distributed,reduced (but not below zero) by the excess(if any) of:

1) The partner's distributive share of thegain that would be recognized had thepartnership sold all its marketable secu-rities of the same class and issuer as thedistributed security at their fair marketvalue immediately before the transactionresulting in the distribution, over

2) The partner's distributive share of thegain that would be recognized had thepartnership sold all such securities it stillheld after the distribution at the fairmarket value in (1).

For the definition of marketable securitiesand other information, see section 731(c) ofthe Internal Revenue Code.

Loss on distribution. A partner does notrecognize loss on a partnership distributionunless all of the following requirements aremet:

1) The adjusted basis of the partner's in-terest in the partnership exceeds thedistribution.

2) The partner's entire interest in the part-nership is liquidated.

3) The distribution is in money, unrealizedreceivables, or inventory items.

There are exceptions to these generalrules. See the following discussions. Also,see Liquidation at Partner's Retirement orDeath under Disposition of Partner's Interest,later.

Distribution of partner's debt. If a partner-ship acquires a partner's debt and extin-guishes the debt by distributing it to the part-ner, the partner will recognize capital gain orloss to the extent the fair market value of thedebt differs from the basis of the debt (deter-mined under the rules discussed in Partner'sBasis for Distributed Property, later).

The partner is treated as having satisfiedthe debt for its fair market value. If the issueprice (adjusted for any premium or discount)of the debt exceeds its fair market value whendistributed, the partner may have to includethat amount in income as canceled debt.

Similarly, a deduction may be available toa corporate partner if the fair market value ofthe debt at the time of distribution exceeds itsadjusted issue price.

Net precontribution gain. A partner gener-ally must recognize gain on the distributionof property (other than money) if the partnercontributed appreciated property to the part-nership during the 5-year period before thedistribution.

CAUTION!

A 7-year period applies to propertycontributed after June 8, 1997, exceptproperty contributed under a written

binding contract:

1) That was in effect on June 8, 1997, andat all times thereafter before the contri-bution, and

2) That provides for the contribution of afixed amount of property.

The gain recognized is the lesser of:

1) The excess of:

a) The fair market value of the prop-erty received in the distribution,over

b) The adjusted basis of the partner'sinterest in the partnership imme-diately before the distribution, re-duced (but not below zero) by anymoney received in the distribution,or

2) The “net precontribution gain” of thepartner. This is the net gain thedistributee partner would recognize if allthe property contributed by the partnerwithin 5 years (7 years for property con-tributed after June 8, 1997) of the distri-bution, and held by the partnership im-mediately before the distribution, weredistributed to another partner, other thana partner who owns more than 50% ofthe partnership. See Distribution of con-tributed property to another partner un-der Contribution of Property, later.

The character of the gain is determinedby reference to the character of the net pre-contribution gain. This gain is in addition toany gain the partner must recognize if themoney distributed is more than his or herbasis in the partnership.

For these rules, the term “money” includesmarketable securities treated as money, asdiscussed earlier.

Effect on basis. The adjusted basis ofthe partner's interest in the partnership is in-creased by any net precontribution gain rec-ognized by the partner. Other than for pur-poses of determining the gain, the increaseis treated as occurring immediately before thedistribution. See Basis of Partner's Interest,later.

The partnership must adjust its basis inany property the partner contributed within 5years (7 years for property contributed afterJune 8, 1997) of the distribution to reflect anygain that partner recognizes under this rule.

Exceptions. If any of the distributedproperty is property the partner had contrib-uted to the partnership, the property is nottaken into account in determining either of thefollowing.

1) The excess of the fair market value ofany property received over the adjustedbasis of the partner's interest in thepartnership.

2) The partner's net precontribution gain.

If any interest in an entity is distributed, thisexception does not apply to the extent that thevalue of the interest is due to property con-tributed to the entity after the interest in theentity had been contributed to the partnership.

Recognition of gain under this rule alsodoes not apply to a distribution of either:

1) Unrealized receivables or substantiallyappreciated inventory items of the part-nership, discussed later, in exchange forall or part of a partner's interest in otherpartnership property.

2) Other partnership property in exchangefor all or part of a partner's interest inunrealized receivables or substantiallyappreciated inventory items of the part-nership.

Partner's Basis forDistributed Property Unless there is a complete liquidation of apartner's interest, the basis of property (otherthan money) distributed to the partner by apartnership is its adjusted basis to the part-nership immediately before the distribution.However, the basis of the property to thepartner cannot be more than the adjustedbasis of his or her interest in the partnershipreduced by any money received in the sametransaction.

Example 1. The adjusted basis of Beth'spartnership interest is $30,000. She receivesa distribution of property that has an adjustedbasis of $20,000 to the partnership and$4,000 in cash. Her basis for the property is$20,000.

Example 2. The adjusted basis of Mike'spartnership interest is $10,000. He receivesa distribution of $4,000 cash and property thathas an adjusted basis to the partnership of$8,000. His basis for the distributed propertyis limited to $6,000 ($10,000 − $4,000, thecash he receives).

Complete liquidation of partner's interest.The basis of property received in completeliquidation of a partner's interest is the ad-justed basis of the partner's interest in the

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partnership reduced by any money distributedto the partner in the same transaction.

Partner's holding period. A partner's hold-ing period for property distributed to the part-ner includes the period the property was heldby the partnership. If the property was con-tributed to the partnership by a partner, thenthe period it was held by that partner is alsoincluded.

Basis divided among properties. If thebasis of property received is the adjustedbasis of the partner's interest in the partner-ship (reduced by money received in the sametransaction), it must be divided among theproperties distributed to the partner. Forproperties distributed after August 5, 1997,allocate the basis using the following rules.

1) Allocate the basis first to unrealizedreceivables and inventory items includedin the distribution by assigning a basisto each item equal to the partnership'sadjusted basis in the item immediatelybefore the distribution. If the total ofthese assigned bases exceeds theallocable basis, decrease the assignedbases by the amount of the excess.

2) Allocate any remaining basis to proper-ties other than unrealized receivablesand inventory items by assigning a basisto each property equal to the partner-ship's adjusted basis in the property im-mediately before the distribution. If theallocable basis exceeds the total ofthese assigned bases, increase the as-signed bases by the amount of the ex-cess. If the total of these assigned basesexceeds the allocable basis, decreasethe assigned bases by the amount of theexcess.

Allocating a basis increase. Allocateany basis increase required in rule (2) abovefirst to properties with unrealized appreciationto the extent of the unrealized appreciation.(If the basis increase is less than the totalunrealized appreciation, allocate it amongthose properties in proportion to their re-spective amounts of unrealized appreciation.)Allocate any remaining basis increase amongall the properties in proportion to their re-spective fair market values.

Example. Julie's basis in her partnershipinterest is $55,000. In a distribution in liqui-dation of her entire interest, she receivesproperties A and B, neither of which is in-ventory or unrealized receivables. Property Ahas an adjusted basis to the partnership of$5,000 and a fair market value of $40,000.Property B has an adjusted basis to the part-nership of $10,000 and a fair market valueof $10,000.

To figure her basis in each property, Juliefirst assigns bases of $5,000 to property Aand $10,000 to property B (their adjustedbases to the partnership). This leaves a$40,000 basis increase (the $55,000allocable basis minus the $15,000 total of theassigned bases). She first allocates $35,000to property A (its unrealized appreciation).The remaining $5,000 is allocated betweenthe properties based on their fair market val-ues, $4,000 ($40,000/$50,000) to property Aand $1,000 ($10,000/$50,000) to property B.Julie's basis in property A is $44,000 ($5,000+ $35,000 + $4,000) and her basis in propertyB is $11,000 ($10,000 + $1,000).

Allocating a basis decrease. Allocateany basis decrease required in rule (1) or rule(2) above as follows:

1) Allocate the basis decrease first to itemswith unrealized depreciation to the extentof the unrealized depreciation. (If thebasis decrease is less than the total un-realized depreciation, allocate it amongthose items in proportion to their re-spective amounts of unrealized depreci-ation.)

2) Allocate any remaining basis decreaseamong all the items in proportion to theirrespective assigned basis amounts (asdecreased in (1)).

Example. Tom's basis in his partnershipinterest is $20,000. In a distribution in liqui-dation of his entire interest, he receivesproperties C and D, neither of which is in-ventory or unrealized receivables. PropertyC has an adjusted basis to the partnershipof $15,000 and a fair market value of $15,000.Property D has an adjusted basis to thepartnership of $15,000 and a fair marketvalue of $5,000.

To figure his basis in each property, Tomfirst assigns bases of $15,000 to property Aand $15,000 to property B (their adjustedbases to the partnership). This leaves a$10,000 basis decrease (the $30,000 total ofthe assigned bases minus the $20,000allocable basis). He allocates the entire$10,000 to property D (its unrealized depre-ciation). Tom's basis in property C is $15,000and his basis in property D is $5,000 ($15,000− $10,000).

Distributions before August 6, 1997.For properties distributed before August 6,1997, allocate the basis using the followingrules.

1) Allocate the basis first to unrealizedreceivables and inventory items includedin the distribution to the extent of thepartnership's adjusted basis in thoseitems. If the partnership's adjusted basisin those items exceeds the allocablebasis, allocate the basis among theitems in proportion to their adjustedbases to the partnership.

2) Allocate any remaining basis to otherdistributed properties in proportion totheir adjusted bases to the partnership.

Example 1. The adjusted basis of Ted'spartnership interest is $30,000. In completeliquidation of his interest, he receives $10,000in cash, his share of the inventory items hav-ing a basis to the partnership of $12,000, andtwo parcels of land having adjusted bases tothe partnership of $12,000 and $4,000.

The basis of Ted's partnership interest isreduced to $20,000 by the $10,000 cash. This$20,000 basis is then divided among theproperties he receives. The inventory itemsin his hands now have a basis of $12,000.To divide the balance of $8,000, he first addsthe partnership's bases for the land ($12,000+ $4,000 = $16,000). The bases of the twoparcels of land in his hands are $6,000[(12,000 ÷ 16,000) × $8,000] and $2,000[(4,000 ÷ 16,000) × $8,000], respectively.

Example 2. Jenny's basis for her part-nership interest is $18,000. In a distributionin liquidation of her entire interest, she re-ceives $12,000 cash, her share of inventoryitems having an adjusted basis to the part-

nership of $12,000, and unrealized receiv-ables having a basis to the partnership of$8,000. The basis of her partnership interestis first reduced to $6,000 by the $12,000 cashshe receives. This $6,000 basis is then di-vided proportionately between the inventoryitems and the unrealized receivables. Herbasis for the inventory items is $3,600[(12,000 ÷ 20,000) × $6,000]. Her basis forthe unrealized receivables is $2,400 [(8,000÷ 20,000) × $6,000].

Partner's interest more than partner-ship basis. If the basis of a partner's interestto be divided in a complete liquidation of thepartner's interest is more than the partner-ship's adjusted basis for the unrealizedreceivables and inventory items distributed,and if no other property is distributed to whichthe partner can apply the remaining basis, thepartner has a capital loss to the extent of theremaining basis of the partnership interest.

Special adjustment to basis of propertyreceived. A partner who acquired any partof his or her partnership interest in a sale orexchange or upon the death of another part-ner may be able choose a special basis ad-justment for the property. In order for thepartner to choose the special adjustment, thedistribution must be made within 2 years afterthe partner acquired the partnership interest.Also, the partnership must not have chosenthe optional adjustment to basis, discussedlater under Adjusting the Basis of PartnershipProperty, when the partner acquired thepartnership interest.

If a partner chooses this special basisadjustment, the partner's basis for the prop-erty distributed is the same as it would havebeen if the partnership had chosen the op-tional adjustment to basis. However, this as-signed basis is not reduced by any depletionor depreciation that would have been allowedor allowable if the partnership had previouslychosen the optional adjustment.

The choice must be made with the part-ner's tax return for the year of the distributionif the distribution includes any property sub-ject to depreciation, depletion, or amorti-zation. If the choice does not have to be madefor the distribution year, it must be made withthe return for the first year in which the basisof the distributed property is pertinent in de-termining the partner's income tax.

A partner choosing this special basis ad-justment must attach a statement to his or hertax return that the partner chooses undersection 732(d) of the Internal Revenue Codeto adjust the basis of property received in adistribution. The statement must show thecomputation of the special basis adjustmentfor the property distributed and list the prop-erties to which the adjustment has been allo-cated.

Example. Bob purchased a 25% interestin X partnership for $17,000 cash. At the timeof the purchase, the partnership owned in-ventory having a basis to the partnership of$14,000 and a fair market value of $16,000.Thus, $4,000 of the $17,000 he paid was at-tributable to his share of inventory with a ba-sis to the partnership of $3,500.

Within 2 years after acquiring his interest,Bob withdrew from the partnership and for hisentire interest received cash of $1,500, in-ventory with a basis to the partnership of$3,500, and other property with a basis of$6,000. The value of the inventory receivedwas 25% of the value of all partnership in-

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ventory. (It is immaterial whether the inven-tory he received was on hand when he ac-quired his interest.)

Since the partnership from which Bobwithdrew did not make the optional adjust-ment to basis, he chose to adjust the basisof the inventory received. His share of thepartnership's basis for the inventory is in-creased by $500 (1/4 of the $2,000 differencebetween the $16,000 fair market value of theinventory and its $14,000 basis to the part-nership at the time he acquired his interest).The adjustment applies only for purposes ofdetermining his new basis in the inventory,and not for purposes of partnership gain orloss on disposition.

The total to be allocated among the prop-erties Bob received in the distribution is$15,500 ($17,000 basis of his interest −$1,500 cash received). His basis in the in-ventory items is $4,000 ($3,500 partnershipbasis + $500 special adjustment). The re-maining $11,500 is allocated to his new basisfor the other property he received.

Mandatory adjustment. A partner doesnot always have a choice whether or not touse this special adjustment to basis. Thespecial adjustment to basis must be made fora distribution of property, whether or not thedistribution is made within 2 years after thepartnership interest was acquired, if all of thefollowing conditions existed when the partnerreceived the partnership interest.

1) The fair market value of all partnershipproperty (other than money) was morethan 110% of its adjusted basis to thepartnership.

2) If there had been a liquidation of thepartner's interest immediately after it wasacquired, an allocation of the basis ofthat interest under the general rules(discussed earlier under Basis dividedamong properties) would have de-creased the basis of property that couldnot be depreciated, depleted, or amor-tized and increased the basis of propertythat could be.

3) The optional basis adjustment, if it hadbeen chosen by the partnership, wouldhave changed the partner's basis for theproperty actually distributed.

Marketable securities. A partner's basis inmarketable securities received in a partner-ship distribution, as determined in the pre-ceding discussions, is increased by any gainrecognized by treating the securities asmoney. See Marketable securities treated asmoney under Partner's Gain or Loss, earlier.The basis increase is allocated among thesecurities in proportion to their respectiveamounts of unrealized appreciation before thebasis increase.

Transactions BetweenPartnership andPartners For certain transactions between a partnerand his or her partnership, the partner istreated as not being a member of the part-nership. These transactions include:

1) Performing services for or transferringproperty to a partnership if—

a) There is a related allocation anddistribution to a partner, and

b) The entire transaction, whenviewed together, is properly char-acterized as occurring between thepartnership and a partner not actingin the capacity of a partner.

2) Transferring money or other property toa partnership if—

a) There is a related transfer of moneyor other property by the partnershipto the contributing partner or an-other partner, and

b) The transfers together are properlycharacterized as a sale or ex-change of property.

Payments by accrual basis partnership tocash basis partner. A partnership that usesan accrual method of accounting cannot de-duct any business expense owed to a cashbasis partner until the amount is paid. How-ever, this rule does not apply to guaranteedpayments made to a partner, which are gen-erally deductible when accrued.

Guaranteed Payments Guaranteed payments are those made by apartnership to a partner that are determinedwithout regard to the partnership's income. Apartnership treats guaranteed payments forservices, or for the use of capital, as if theywere made to a person who is not a partner.This treatment is for purposes of determininggross income and deductible business ex-penses only. For other tax purposes, guar-anteed payments are treated as a partner'sdistributive share of ordinary income. Guar-anteed payments are not subject to incometax withholding.

The partnership generally deducts guar-anteed payments on line 10 of Form 1065 asa business expense. They are also listed onSchedules K and K–1 of the partnership re-turn. The individual partner reports guaran-teed payments on Schedule E (Form 1040)as ordinary income, along with his or herdistributive share of the partnership's otherordinary income.

Guaranteed payments made to partnersfor organizing the partnership or syndicatinginterests in the partnership are capital ex-penses and are not deductible by the part-nership. However, these payments must beincluded in the partners' individual income taxreturns. See Organization expenses andsyndication fees under Partnership Incomeor Loss, earlier.

Minimum payment. If a partner is to receivea minimum payment from the partnership, theguaranteed payment is the amount by whichthe minimum payment is more than the part-ner's distributive share of the partnership in-come before taking into account the guaran-teed payment.

Example. Under a partnership agree-ment, Sandy is to receive 30% of the part-nership income, but not less than $8,000. Thepartnership has net income of $20,000.Sandy's share, without regard to the minimumguarantee, is $6,000 (30% × $20,000). Theguaranteed payment that can be deducted

by the partnership is $2,000 ($8,000 −$6,000). Sandy's income from the partnershipis $8,000, and the remaining $12,000 will bereported by the other partners in proportionto their shares under the partnership agree-ment.

If the partnership net income had been$30,000, there would have been no guaran-teed payment since her share, without regardto the guarantee, would have been greaterthan the guarantee.

Self-employed health insurance premi-ums. Premiums for health insurance paid bya partnership on behalf of a partner for ser-vices as a partner are treated as guaranteedpayments. The partnership can deduct thepayments as a business expense and thepartner must include them in gross income.However, if the partnership accounts for in-surance paid for a partner as a reduction indistributions to the partner, the partnershipcannot deduct the premiums.

For 1997, a partner who qualifies can de-duct 40% of the health insurance premiumspaid by the partnership on his or her behalfas an adjustment to income. The partnercannot deduct the premiums for any calendarmonth or part of a month in which the partneris eligible to participate in any subsidizedhealth plan maintained by any employer ofthe partner or the partner's spouse. For moreinformation on the self-employed health in-surance deduction, see chapter 10 in Publi-cation 535.

Note. For 1998, a partner who qualifiescan deduct 45% of the health insurance pre-miums paid on his or her behalf as an ad-justment to income.

Including payments in partner's income.Guaranteed payments are included in incomein the partner's tax year in which the partner-ship's tax year ends.

Example 1. Under the terms of a part-nership agreement, Erica is entitled to a fixedannual payment of $10,000 without regard tothe income of the partnership. Her distributiveshare of the partnership income is 10%. Thepartnership has $50,000 of ordinary incomeafter deducting the guaranteed payment. Shemust include ordinary income of $15,000 onher individual income tax return for her taxyear in which the partnership's tax year ends($10,000 guaranteed payment + $5,000($50,000 × 10%) distributive share).

Example 2. Mike is a calendar year tax-payer who is a partner in a partnership. Thepartnership is on a fiscal year that endedJanuary 31, 1997. Mike received guaranteedpayments from the partnership from February1, 1996, until December 31, 1996. He mustinclude these guaranteed payments in in-come for 1997 and report them on his 1997income tax return.

Payments resulting in loss. If a part-nership agreement provides for guaranteedpayments to a partner and the payments re-sult in a partnership loss in which the partnershares, the partner must:

1) Report the full amount of the guaranteedpayments as ordinary income, and

2) Separately take into account the appro-priate distributive share of the partner-ship loss.

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Sale or Exchangeof PropertySpecial rules apply to a sale or exchange ofproperty between a partnership and certainpersons.

Losses. Losses will not be allowed from asale or exchange of property (other than aninterest in the partnership) directly or indi-rectly between a partnership and a personwhose direct or indirect interest in the capitalor profits of the partnership is more than 50%.

If the sale or exchange is between twopartnerships in which the same persons di-rectly or indirectly own more than 50% of thecapital or profits interests in each partnership,no deduction of a loss is allowed.

The basis of each partner's interest in thepartnership is decreased (but not below zero)by the partner's share of the disallowed loss.

If the purchaser later sells the property,only the gain realized greater than the lossnot allowed will be taxable. If any gain fromthe sale of the property is not recognized be-cause of this rule, the basis of each partner'sinterest in the partnership is increased by thepartner's share of that gain.

Gains. Gains are treated as ordinary incomein a sale or exchange of property directly orindirectly between a person and a partner-ship, or between two partnerships, if both ofthe following apply:

1) More than 50% of the capital or profitsinterest in the partnership(s) is directlyor indirectly owned by the sameperson(s), and

2) The property in the hands of thetransferee immediately after the transferis not a capital asset. Property that is nota capital asset includes accountsreceivable, inventory, stock-in-trade, anddepreciable or real property used in atrade or business.

More than 50% ownership. To determine ifthere is more than 50% ownership in part-nership capital or profits, the following rulesapply.

1) An interest directly or indirectly ownedby or for a corporation, partnership, es-tate, or trust is considered to be ownedproportionately by or for its shareholders,partners, or beneficiaries.

2) An individual is considered to own theinterest directly or indirectly owned byor for the individual's family. For this rule,“family” includes only brothers, sisters,half-brothers, half-sisters, spouses, an-cestors, and lineal descendants.

3) If a person is considered to own an in-terest using rule (1), that person (the“constructive owner”) is treated as if ac-tually owning that interest when rules (1)and (2) are applied. However, if a personis considered to own an interest usingrule (2), that person is not treated asactually owning that interest in reapply-ing rule (2) to make another person theconstructive owner.

Example. Individuals A and B and TrustT are equal partners in Partnership ABT. A'shusband, AH, is the sole beneficiary of TrustT. Trust T's partnership interest will be attri-buted to AH only for the purpose of further

attributing the interest to A. As a result, A isa more-than-50% partner. This means thatany deduction for losses on transactions be-tween her and ABT will not be allowed, andgain from property that in the hands of thetransferee is not a capital asset is treated asordinary, rather than capital, gain.

More information. For more information onthese special rules, see Sales and ExchangesBetween Related Parties in chapter 2 ofPublication 544.

Contribution of Property Usually, neither the partners nor the partner-ship recognize a gain or loss when propertyis contributed to the partnership in exchangefor a partnership interest. This applieswhether a partnership is being formed or isalready operating. The partnership's holdingperiod for the property includes the partner'sholding period.

The contribution of limited partnership in-terests in one partnership for limited partner-ship interests in another partnership qualifiesas a tax-free contribution of property to thesecond partnership if the transaction is madefor business purposes. The exchange is notsubject to the rules explained later underDisposition of Partner's Interest.

Disguised sales. A contribution of moneyor other property to the partnership followedby a distribution of different property from thepartnership to the partner is treated not as acontribution and distribution, but as a sale ofproperty, if:

1) The distribution would not have beenmade but for the contribution, and

2) The partner's right to the distributiondoes not depend on the success ofpartnership operations.

All facts and circumstances are consid-ered in determining if the contribution anddistribution are more properly characterizedas a sale. However, if the contribution anddistribution occur within two years of eachother, the transfers are presumed to be a saleunless the facts clearly indicate that thetransfers are not a sale. If the contribution anddistribution occur more than two years apart,the transfers are presumed not to be a saleunless the facts clearly indicate that thetransfers are a sale.

Form 8275 required. A partner must at-tach Form 8275 (or other statement) to hisor her return if the partner contributes prop-erty to a partnership and, within two years(before or after the contribution), the partner-ship transfers money or other considerationto the partner. For exceptions to this require-ment, see section 1.707–3(c)(2) of the In-come Tax Regulations.

A partnership must attach Form 8275 (orother statement) to its return if it distributesproperty to a partner, and, within two years(before or after the distribution), the partnertransfers money or other consideration to thepartnership.

Form 8275 must include the following in-formation.

1) A caption identifying the statement as adisclosure under Internal Revenue Codesection 707.

2) A description of the transferred propertyor money, including its value.

3) A description of any facts that are rele-vant in determining if the transfers areproperly viewed as a disguised sale.(See section 1.707–3(b)(2) of the In-come Tax Regulations for a descriptionof the facts and circumstances that areconsidered in determining if the transfersare a disguised sale.)

Contribution to investment company.Gain is recognized when property is contrib-uted (in exchange for an interest in the part-nership) to a partnership that would betreated as an investment company if it wereincorporated. A loss realized on a contributionof stock, securities, or other property to apartnership is not recognized.

A partnership is treated as an investmentcompany if over 80% of the value of its as-sets, excluding cash and nonconvertible debtobligations, is held for investment and con-sists of readily marketable stocks, securities,or interests in regulated investment compa-nies or real estate investment trusts. Whethera partnership is an investment company un-der this test is ordinarily determined imme-diately after the transfer of property.

These rules apply to limited partnershipsand general partnerships, regardless ofwhether they are privately formed or publiclysyndicated.

Basis of contributed property. If a partnercontributes property to a partnership, thepartnership's basis for determining depreci-ation, depletion, and gain or loss for theproperty is the same as the partner's adjustedbasis for the property when it was contributed,increased by any gain recognized by thepartner at the time of contribution.

Allocations to account for built-in gain orloss. The fair market value of property at thetime it is contributed may be different from thepartner's adjusted basis. The partnershipmust allocate among the partners any in-come, deduction, gain, or loss on the propertyin a manner that will account for the differ-ence. This rule also applies to contributionsof accounts payable and other accrued butunpaid items of a cash basis partner.

The partnership can use different allo-cation methods for different items of contrib-uted property. A single reasonable methodmust be consistently applied to each item,and the overall method or combination ofmethods must be reasonable. See Regu-lations section 1.704–3 for allocation methodsgenerally considered reasonable.

If the partnership sells contributed prop-erty and recognizes gain or loss, built-in gainor loss is allocated to the contributing partner.If contributed property is subject to depreci-ation or other cost recovery, the allocation ofdeductions for these items takes into accountbuilt-in gain or loss on the property. However,the total depreciation, depletion, gain, or lossallocated to partners cannot be more than thedepreciation or depletion allowable to thepartnership or the gain or loss realized by thepartnership.

Example. Sara and Gail form an equalpartnership. Sara contributed $10,000 in cashto the partnership and Gail contributeddepreciable property with a fair market valueof $10,000 and an adjusted basis of $4,000.The partnership's basis for depreciation islimited to the adjusted basis of the propertyin Gail's hands, $4,000.

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In effect, Sara purchased an undividedone-half interest in the depreciable propertywith her contribution of $10,000. Assumingthat the depreciation rate is 10% a year underthe General Depreciation System (GDS), shewould have been entitled to a depreciationdeduction of $500 per year, based on her in-terest in the partnership.

However, since the partnership is allowedonly $400 per year of depreciation (10% of$4,000), no more than $400 can be allocatedbetween the partners. The entire $400 mustbe allocated to Sara.

Distribution of contributed property to an-other partner. If a partner contributes prop-erty to a partnership and the partnership dis-tributes the property to another partner within5 years of the contribution, the contributingpartner must recognize gain or loss on thedistribution.

CAUTION!

A 7-year period applies to propertycontributed after June 8, 1997, exceptproperty contributed under a written

binding contract:

1) That was in effect on June 8, 1997, andat all times thereafter before the contri-bution, and

2) That provides for the contribution of afixed amount of property.

The recognized gain or loss is the amountthe contributing partner would have recog-nized, because of the difference between theproperty's basis and its fair market value atthe time of contribution, if the property hadbeen sold for its fair market value when it wasdistributed. The character of the gain or losswill be the same as the character that wouldhave resulted if the partnership had sold theproperty to the distributee partner. Appropri-ate adjustments must be made to the ad-justed basis of the contributing partner'spartnership interest and to the adjusted basisof the property distributed to reflect the rec-ognized gain or loss.

Disposition of certain contributed prop-erty. The following rules determine thecharacter of the partnership's gain or loss ona later disposition of certain types of property.

1) Unrealized receivables. For propertythat was an unrealized receivable in thehands of the contributing partner, anygain or loss on a disposition by thepartnership is ordinary income or loss.Unrealized receivables are defined laterunder Payments for Unrealized Receiv-ables and Inventory Items. When read-ing the definition, substitute “partner” for“partnership.”

2) Inventory items. For property that wasan inventory item in the hands of thecontributing partner, a gain or loss on adisposition by the partnership within 5years after the contribution is ordinaryincome or loss. Inventory items are de-fined later in Payments for UnrealizedReceivables and Inventory Items.

3) Capital loss property. For property thatwas a capital asset in the contributingpartner's hands, any loss on a disposi-tion by the partnership within 5 yearsafter the contribution is a capital loss.The capital loss is limited to the amountby which the partner's adjusted basis for

the property exceeded the property's fairmarket value immediately before thecontribution.

4) Substituted basis property. If the part-nership disposes of any of the aboveproperty in a nonrecognition transaction,these rules apply if the recipient of theproperty disposes of any substituted ba-sis property resulting from the trans-action.

Contribution of Services A partner can acquire an interest in partner-ship capital or profits as compensation forservices performed or to be performed.

Capital interest. A capital interest is an in-terest that would give the holder a share ofthe proceeds if the partnership's assets weresold at fair market value and the proceedswere distributed in a complete liquidation ofthe partnership. This determination generallyis made at the time of receipt of the partner-ship interest. The fair market value of suchan interest received by a partner as compen-sation for services must generally be includedin the partner's gross income in the first taxyear in which the partner can transfer the in-terest or the interest is not subject to a sub-stantial risk of forfeiture. The partnership in-terest transferred as compensation forservices is subject to the rules discussed inchapter 2 of Publication 535 under Paymentin Restricted Property.

The fair market value of an interest inpartnership capital transferred to a partner aspayment for services to the partnership is aguaranteed payment, discussed earlier.

Profits interest. A profits interest is a part-nership interest other than a capital interest.If a person receives a profits interest for pro-viding services to or for the benefit of a part-nership in a partner capacity or in anticipationof being a partner, the receipt of such an in-terest is not a taxable event for the partneror the partnership. However, this does notapply in the following situations.

1) The profits interest relates to a substan-tially certain and predictable stream ofincome from partnership assets, such asincome from high-quality debt securitiesor a high-quality net lease.

2) Within 2 years of receipt, the partnerdisposes of the profits interest.

3) The profits interest is a limited partner-ship interest in a publicly traded part-nership.

Basis of Partner'sInterest The basis of a partnership interest acquiredby a contribution of property, includingmoney, is the money a partner contributedplus the adjusted basis of any property he orshe contributed. If the partner must recognizegain as a result of the contribution, this gainis included in the basis of his or her interest.Any increase in a partner's individual liabilitiesbecause of an assumption of partnership li-abilities is considered a contribution of moneyto the partnership by the partner.

Interest acquired by gift, etc. If a partneracquires an interest in a partnership by gift,inheritance, or under any circumstance otherthan by a contribution of money or propertyto the partnership, the partner's basis mustbe determined using the basis rules describedin Publication 551.

Adjusted Basis The partner's basis is increased or decreasedby the following items.

Increases. The basis of an interest in apartnership is increased by the partner's:

1) Additional contributions to the partner-ship, including an increased share of orassumption of partnership liabilities.

2) Distributive share of taxable and non-taxable partnership income.

3) Distributive share of the excess of thedeductions for depletion over the basisof the depletable property.

Decreases. The partner's basis is decreased(but never below zero) by:

1) The money (including a decreased shareof partnership liabilities or an assumptionof the partner's individual liabilities by thepartnership) and adjusted basis of prop-erty distributed to the partner by thepartnership.

2) The partner's distributive share of thepartnership losses (including capitallosses).

3) The partner's distributive share of non-deductible partnership expenses that arenot capital expenditures.

4) The partner's deduction for depletion forany partnership oil and gas wells, up tothe proportionate share of the adjustedbasis of the wells allocated to the part-ner.

5) The partner's share of any section 179expenses, even if the partner cannotdeduct the entire amount on his or herindividual income tax return.

Partner's liabilities assumed by part-nership. If contributed property is subject toa debt or if a partner's liabilities are assumedby the partnership, the basis of that partner'sinterest is reduced (but not below zero) by theliability assumed by the other partners. Thispartner must reduce his or her basis becausethe assumption of the liability is treated as adistribution of money to that partner. Theother partners' assumption of the liability istreated as a contribution by them of moneyto the partnership. See Effect of PartnershipLiabilities, later.

Example 1. John acquired a 20% interestin a partnership by contributing property thathad an adjusted basis to him of $8,000 anda $4,000 mortgage. The partnership assumedpayment of the mortgage. The basis of John'sinterest is:

Example 2. If, in the above example, thecontributed property had a $12,000 mortgage,the basis of John's partnership interest would

Adjusted basis of contributed property ........ $8,000

Minus: Part of mortgage assumed by otherpartners (80% × $4,000) .............................. 3,200

Basis of John's partnership interest ............ $4,800

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be zero. The $1,600 difference between themortgage assumed by the other partners,$9,600 (80% × $12,000), and his basis of$8,000 would be treated as capital gain fromthe sale or exchange of a partnership interest.However, this gain would not increase thebasis of his partnership interest.

Book value of partner's interest. The ad-justed basis of a partner's interest is deter-mined without considering any amount shownin the partnership books as a capital, equity,or similar account.

Example. Sam contributes to his part-nership property that has an adjusted basisof $400 and a fair market value of $1,000.His partner contributes $1,000 cash. Whileeach partner has increased his capital ac-count by $1,000, which will be reflected in thepartnership books, the adjusted basis ofSam's interest is only $400 and the adjustedbasis of his partner's interest is $1,000.

When determined. The adjusted basis of apartner's partnership interest is ordinarily de-termined at the end of the partnership's taxyear. However, if there has been a sale orexchange of all or part of the partner's interestor a liquidation of his or her entire interest ina partnership, the adjusted basis is deter-mined on the date of sale, exchange, or liq-uidation.

Alternative rule for figuring adjusted ba-sis. In certain cases, the adjusted basis ofa partnership interest can be figured by usingthe partner's share of the adjusted basis ofpartnership property that would be distributedif the partnership terminated.

This alternative rule can be used if eitherof the following applies.

1) The circumstances are such that thepartner cannot practicably apply thegeneral basis rules.

2) It is, in the opinion of the IRS, reason-able to conclude that the result producedwill not vary substantially from the resultunder the general basis rules.

Adjustments may be necessary in figuringthe adjusted basis of a partnership interestunder the alternative rule. For example, ad-justments would be required to include in thepartner's share of the adjusted basis of part-nership property any significant discrepanciesthat resulted from contributed property,transfers of partnership interests, or distribu-tions of property to the partners.

Effect of PartnershipLiabilities A partner's basis in a partnership interest in-cludes the partner's share of a partnership li-ability only if, and to the extent that, the li-ability:

1) Creates or increases the partnership'sbasis in any of its assets,

2) Gives rise to a current deduction to thepartnership, or

3) Constitutes a nondeductible, noncapitalexpense of the partnership.

The term “assets” in (1) above includes capi-talized items allocable to future periods, suchas organization expenses.

A partner's share of accrued but unpaidexpenses or accounts payable of a cash ba-sis partnership are not included in the ad-justed basis of the partner's interest in thepartnership.

Partner's basis increased. If a partner'sshare of partnership liabilities increases, or apartner's individual liabilities increase be-cause he or she assumes partnership liabil-ities, this increase is treated as a contributionof money by the partner to the partnership.

Partner's basis decreased. If a partner'sshare of partnership liabilities decreases, ora partner's individual liabilities decrease be-cause the partnership assumes his or her in-dividual liabilities, this decrease is treated asa distribution of money to the partner by thepartnership.

Assumption of liability. A partner or relatedperson is considered to assume a partnershipliability only to the extent that:

1) He or she is personally liable for it, and

2) The creditor knows that the liability wasassumed by the partner or a person re-lated to the partner. The creditor mustalso be able to demand payment fromthe partner, and no other partner orperson related to another partner maybear the economic risk of loss on thatliability immediately after the assump-tion.

Related person. A related person, forthese purposes, includes:

1) An individual and his or her spouse, an-cestors, and lineal descendants.

2) An individual and a corporation 80% ormore in value of the outstanding stockof which is owned, directly or indirectly,by or for such individual.

3) Two corporations that are members ofthe same controlled group.

4) A grantor and a fiduciary of any trust.

5) Fiduciaries of two separate trusts if thesame person is a grantor of both trusts.

6) A fiduciary and a beneficiary of the sametrust.

7) A fiduciary and a beneficiary of twoseparate trusts if the same person is agrantor of both trusts.

8) A fiduciary of a trust and a corporation,80% or more in value of the outstandingstock of which is owned, directly or indi-rectly, by or for the trust or a grantor ofthe trust.

9) A person and a tax-exempt educationalor charitable organization controlled di-rectly or indirectly by the person or bymembers of the person's family.

10) A corporation and a partnership if thesame persons own 80% or more in valueof the outstanding stock of the corpo-ration and 80% or more of the capital orprofits interest in the partnership.

11) Two S corporations or an S corporationand a C corporation if the same personsown 80% or more in value of the out-standing stock of each corporation.

12) For tax years beginning after August 5,1997, an executor and a beneficiary ofan estate.

13) A partnership and a person owning, di-rectly or indirectly, 80% or more of thecapital or profits interest in the partner-ship.

14) Two partnerships in which the samepersons own, directly or indirectly, 80%or more of the capital or profits interests.

Property subject to a liability. If prop-erty contributed to a partnership by a partneror distributed by the partnership to a partneris subject to a liability, the transferee istreated as having assumed the liability to theextent it does not exceed the fair market valueof the property.

Partner's share of recourse liabilities. Apartnership liability is a recourse liability to theextent that any partner or related person hasan economic risk of loss for that liability. Apartner's share of a recourse liability equalshis or her economic risk of loss for that liabil-ity. A partner has an economic risk of loss ifthat partner or related person, defined earlier,would be obligated (whether by agreementor law) to make a net payment to the creditoror a contribution to the partnership with re-spect to the liability if the partnership wereconstructively liquidated. A partner who is thecreditor for a liability that would otherwise bea nonrecourse liability of the partnership hasan economic risk of loss in that liability.

Constructive liquidation. Generally, ina constructive liquidation, the following eventsare treated as occurring at the same time.

1) All partnership liabilities become payablein full.

2) All of the partnership's assets have avalue of zero, except for property con-tributed to secure a liability.

3) All property is disposed of by the part-nership in a fully taxable transaction forno consideration (except relief from li-abilities for which the creditor's right toreimbursement is limited solely to oneor more assets of the partnership).

4) All items of income, gain, loss, or de-duction are allocated to the partners.

5) The partnership liquidates.

Example. Ted and Jane form a cash ba-sis general partnership with cash contribu-tions of $20,000 each. Under the partnershipagreement, they share all partnership profitsand losses equally. They borrow $60,000 andpurchase depreciable business equipment.This debt is included in the partners' basis inthe partnership because incurring it createsan additional $60,000 of basis in the partner-ship's depreciable property.

If neither partner has an economic risk ofloss in the liability, it is a nonrecourse liability.Each partner's basis would include his or hershare of the liability, $30,000.

If Jane is required to pay the creditor if thepartnership defaults, she has an economicrisk of loss in the liability. Her basis in thepartnership would be $80,000 ($20,000 +$60,000), while Ted's basis would be$20,000.

Limited partner. A limited partner gen-erally has no obligation to contribute addi-tional capital to the partnership and thereforedoes not have an economic risk of loss in

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partnership recourse liabilities. Thus, absentsome other factor, such as the guarantee ofa partnership liability by the limited partneror the limited partner making the loan to thepartnership, a limited partner generally doesnot have a share of partnership recourse li-abilities.

Partner's share of nonrecourse liabilities.A partnership liability is a nonrecourse liabilityif no partner or related person has an eco-nomic risk of loss for that liability. A partner'sshare of nonrecourse liabilities is generallyproportionate to his or her share of partner-ship profits. However, this rule may not applyif the partnership has taken deductions at-tributable to nonrecourse liabilities or thepartnership holds property that was contrib-uted by a partner. See section 1.752–3 of theIncome Tax Regulations for more information.

More information. For more information onthe effect of partnership liabilities, includingrules for limited partners and examples, seesections 1.752–1 through 1.752–5 of the In-come Tax Regulations.

Disposition ofPartner's InterestThe following discussions explain the treat-ment of gain or loss from the disposition ofan interest in a partnership.

Abandoned or worthless partnership in-terest. A loss incurred from the abandon-ment or worthlessness of a partnership inter-est is an ordinary loss only if:

1) The transaction is not a sale or ex-change, and

2) The partner has not received an actualor deemed distribution from the partner-ship.

If the partner receives even a de minimis ac-tual or deemed distribution, the entire loss isa capital loss.

Sale, Exchange,or Other Transfer The sale or exchange of a partner's interestin a partnership usually results in capital gainor loss. However, see Payments for Unreal-ized Receivables and Inventory Items, later,for certain exceptions. Gain or loss is the dif-ference between the amount realized and theadjusted basis of the partner's interest in thepartnership. If the selling partner is relievedof any partnership liabilities, that partner mustinclude the liability relief as part of the amountrealized for his or her interest.

Example 1. Fred became a limited part-ner in the ABC Partnership by contributing$10,000 in cash on the formation of the part-nership. The adjusted basis of his partnershipinterest at the end of the current year is$20,000, which includes his $15,000 shareof partnership liabilities. The partnership hasno unrealized receivables or substantiallyappreciated inventory items. Fred sells hisinterest in the partnership for $10,000 in cash.He had been paid his share of the partnershipincome for the tax year.

Fred realizes $25,000 from the sale of hispartnership interest ($10,000 cash payment

+ $15,000 liability relief). He reports $5,000($25,000 realized − $20,000 basis) as a cap-ital gain.

Example 2. The facts are the same asExample 1, except that Fred withdraws fromthe partnership when the adjusted basis ofhis interest in the partnership is zero. He isconsidered to have received a distribution of$15,000, his relief of liability. He reports acapital gain of $15,000.

Partnership election to adjust basis ofpartnership property. Generally, a partner-ship's basis in its assets is not affected by atransfer of an interest in the partnership,whether by sale or exchange or because ofthe death of a partner. However, the partner-ship can elect to make an optional adjustmentto basis in the year of transfer. See Adjustingthe Basis of Partnership Property, later, forinformation on making the election.

Exchange of partnership interests. An ex-change of partnership interests generallydoes not qualify as a nontaxable exchangeof like-kind property. This applies regardlessof whether they are general or limited part-nership interests or interests in the same ordifferent partnerships. However, under certaincircumstances, such an exchange may betreated as a tax-free contribution of propertyto a partnership. See Contribution of Property,earlier.

An interest in a partnership that has a validelection in effect under section 761(a) of theInternal Revenue Code to be excluded fromthe partnership rules of the Code is treatedas an interest in each of the partnership as-sets and not as a partnership interest. SeeExclusion From Partnership Rules, earlier.

Installment reporting for sale of partner-ship interest. A partner who sells a partner-ship interest at a gain may be able to reportthe sale on the installment method. For re-quirements and other information on an in-stallment sale, see Publication 537, Install-ment Sales.

The gain from the installment sale istreated as part capital gain and part ordinaryincome if the partnership's assets includedunrealized receivables and substantially ap-preciated inventory items. See Payments forUnrealized Receivables and Inventory Items,later.

An allocation must be made to ensure thatthe income is correctly reported. The gain al-located to unrealized receivables and sub-stantially appreciated inventory items is gen-erally ordinary income and must be reportedin the year of sale. The gain allocated to theother assets is capital gain and can be re-ported under the installment method.

Liquidation at Partner'sRetirement or Death Payments made by the partnership to a retir-ing partner or successor in interest of a de-ceased partner in return for the partner's en-tire interest in the partnership may have tobe allocated between payments in liquidationof the partner's interest in partnership prop-erty and other payments.

For income tax purposes, a retiring partneror successor in interest to a deceased partneris treated as a partner until his or her interestin the partnership has been completely liqui-dated.

Payments in liquidation of interest inpartnership property. Payments made inliquidation of the interest of a retiring or de-ceased partner in exchange for his or her in-terest in partnership property are considereda distribution, not a distributive share orguaranteed payment that could give rise to adeduction (or its equivalent) for the partner-ship.

Unrealized receivables and goodwill.Payments in exchange for an interest inpartnership property do not include amountspaid for:

1) Unrealized receivables of the partner-ship, or

2) Goodwill of the partnership, except to theextent the partnership agreement pro-vides for a payment for goodwill.

Unrealized receivables are defined inPayments for Unrealized Receivables andInventory Items, later. However, for this pur-pose, unrealized receivables do not includethe Other items treated as unrealized receiv-ables listed in that discussion.

This rule about unrealized receivables andgoodwill of the partnership applies to partnersretiring or dying on or after January 5, 1993(unless a written contract to purchase the re-tiring partner's interest in the partnership wasbinding on January 4, 1993, and at all timesthereafter), only if:

1) Capital is not a material income-producing factor for the partnership, and

2) The retiring or deceased partner was ageneral partner in the partnership.

If the partner was not a general partneror if capital is a material income-producingfactor, the partnership will not receive a de-duction or its equivalent (distributive share)for the payments.

Capital is not a material income-producingfactor if substantially all the gross income ofthe business consists of fees, commissions,or other compensation for personal servicesperformed by a partner or the partnership'semployees. The practice of his or her profes-sion by a physician, dentist, lawyer, architect,or accountant is treated as a trade or busi-ness in which capital is not a materialincome-producing factor. This rule applieseven though the practitioner may have asubstantial capital investment in the profes-sional equipment or physical plant of thepractice, so long as the capital investment ismerely incidental to the professional practice.

Partners' valuation. Generally, the part-ners' valuation of a partner's interest in part-nership property in an arm's-length agree-ment will be treated as correct. If the valuationreflects only the partner's net interest in theproperty (total assets less liabilities), it mustbe adjusted so that both the value of and thebasis for the partner's interest include thepartner's share of partnership liabilities.

Gain or loss on distribution. Upon thereceipt of the distribution, the retiring partneror successor in interest of a deceased partnerwill recognize gain only to the extent that anymoney (and marketable securities treated asmoney) distributed is more than the partner'sadjusted basis in the partnership. The partnerwill recognize a loss only if the distribution isin money, unrealized receivables, and inven-tory items. No loss is recognized if any otherproperty is received.

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Other payments. Payments made by thepartnership to a retiring partner or successorin interest of a deceased partner that are notmade in exchange for an interest in partner-ship property are treated as distributiveshares of partnership income or guaranteedpayments. This rule applies regardless of thetime over which the payments are to bemade. It applies to payments made for thepartner's share of unrealized receivables andgoodwill not treated as a distribution.

If the amount is based on partnership in-come, the payment is taxable as a distributiveshare of partnership income. The paymentretains the same character when reported bythe recipient that it would have had if reportedby the partnership. For more information, seePartner's Distributive Share, earlier, and Dis-tributive Share in Year of Disposition, later.

If the amount is not based on partnershipincome, it is treated as a guaranteed pay-ment. The recipient reports guaranteed pay-ments as ordinary income. For additional in-formation on guaranteed payments, seeTransactions Between Partnership and Part-ners, earlier.

These payments are included in incomeby the recipient for his or her tax year thatincludes the end of the partnership tax yearfor which the payments are a distributiveshare or in which the partnership is entitledto deduct them as guaranteed payments.

Former partners who continue to makeguaranteed periodic payments to satisfy thepartnership's liability to a retired partner afterthe partnership is terminated can deduct thepayments as a business expense in the yearpaid.

Payments for UnrealizedReceivables and InventoryItemsIf a partner receives money or property inexchange for any part of a partnership inter-est, the amount due to his or her share of thepartnership's unrealized receivables or sub-stantially appreciated inventory items resultsin ordinary income or loss. This amount istreated as if it were received for the sale orexchange of property that is not a capital as-set.

This treatment applies to the unrealizedreceivables part of payments to a retiringpartner or successor in interest of a deceasedpartner only if that part is not treated as paidin exchange for partnership property. SeePayments in liquidation of interest in partner-ship property earlier.

CAUTION!

For a sale or exchange of a partner-ship interest after August 5, 1997, itis no longer necessary that inventory

be substantially appreciated before it gener-ates ordinary income (rather than capitalgain). However, this does not apply to anysale or exchange under a written contract thatis in effect on June 8, 1997, and at all timesthereafter before the sale or exchange.

Unrealized receivables. Unrealized receiv-ables are any rights to payment not alreadyincluded in income for:

1) Goods delivered or to be delivered to theextent the payment would be treated asreceived for property other than a capitalasset, or

2) Services rendered or to be rendered.

These rights must have arisen under acontract or agreement that existed at the timeof sale or distribution, even though the part-nership may not be able to enforce paymentuntil a later date. For example, unrealizedreceivables include accounts receivable of acash method partnership and rights to pay-ment for work or goods begun but incompleteat the time of the sale or distribution of thepartner's share.

The basis for any unrealized receivablesincludes all costs or expenses for the receiv-ables that were paid or accrued but not pre-viously taken into account under the partner-ship's method of accounting.

Other items treated as unrealizedreceivables. Unrealized receivables includepotential gain that would be ordinary incomeif the following partnership property were soldat its fair market value on the date of thepayment.

1) Mining property for which explorationexpenses were deducted.

2) Stock in a Domestic International SalesCorporation (DISC).

3) Certain farm land for which expenses forsoil and water conservation or landclearing were deducted.

4) Franchises, trademarks, or trade names.

5) Oil, gas, or geothermal property forwhich intangible drilling and develop-ment costs were deducted.

6) Stock of certain controlled foreign cor-porations.

7) Market discount bonds and short-termobligations.

8) Property subject to recapture of depre-ciation under sections 1245 and 1250of the Internal Revenue Code. Depreci-ation recapture is discussed in chapter4 of Publication 544.

Determining value. Generally, anyarm's-length agreement between the buyerand the seller (or between the partnershipand the partner receiving the distribution) willestablish the amount or value of:

1) The sales price of unrealized receiv-ables, or

2) The value of the receivables received ina distribution treated as a sale or ex-change.

If no agreement exists, an allowance mustbe made for the estimated cost to completeperformance of the contract or agreement,and for the time between the sale or distribu-tion and the time of payment.

Example. You are a partner in ABCPartnership. The adjusted basis of your part-nership interest at the end of the current yearis zero. Your share of potential ordinary in-come from partnership depreciable propertyis $5,000. The partnership has no other un-realized receivables or inventory items. Yousell your interest in the partnership for$10,000 in cash and you report the entireamount as a gain since your adjusted basisin the partnership is zero. You report as ordi-nary income your $5,000 share of potentialordinary income from the partnership'sdepreciable property. The remaining $5,000gain is a capital gain.

Inventory items that have appreciatedsubstantially in value. Inventory items ofthe partnership are considered to have ap-preciated substantially in value if, at the timeof the sale or distribution, their total fair mar-ket value is more than 120% of the partner-ship's adjusted basis for the property. How-ever, if a principal purpose for acquiringinventory property is to avoid ordinary incometreatment by reducing the appreciation to lessthan 120%, that property is excluded.

Items included as inventory. Inventoryitems are not just stock-in-trade of the part-nership. They include inventory on hand atthe end of the tax year or held primarily forsale to customers in the normal course ofbusiness. They include any asset which, ifsold or exchanged by the partnership, wouldnot be a capital asset or section 1231 prop-erty (real or depreciable business propertyheld more than one year). For example, ac-counts receivable acquired for services orfrom the sale of inventory and unrealizedreceivables are inventory items. Inventoryitems also include any other property held bythe partnership that would be considered in-ventory if held by the selling or distributeepartner.

Example. Assume that you sold yourone-third interest in your partnership onMarch 20, 1997. The partnership used anaccrual method of accounting, had no liabil-ities, and had the following assets:

The inventory items—the accountsreceivable, trade notes receivable, andmerchandise—had a total adjusted basis of$11,000 and a fair market value of $14,100.The total value of all assets other than cashwas $114,100. Because the fair market valueof the inventory items ($14,100) was morethan 120% of their adjusted basis ($11,000),the partnership had substantially appreciatedinventory items. The amount you received foryour interest in the inventory items that ex-ceeded your basis in them is ordinary income.

Notification of partnership. If a partner ex-changes a partnership interest attributable tounrealized receivables or inventory (substan-tially appreciated inventory if the exchangewas before August 6, 1997) for money orproperty, he or she must notify the partner-ship in writing. This must be done within 30days of the transaction or, if earlier, by Janu-ary 15 of the calendar year following the cal-endar year of the exchange. A partner maybe subject to a $50 penalty for each failure tonotify the partnership about such a trans-action, unless the failure was due to reason-able cause and not willful neglect.

Information return required of partnership.When a partnership is notified of an exchangeof partnership interests involving unrealizedreceivables or inventory items, the partner-ship must file Form 8308, Report of a Saleor Exchange of Certain Partnership Interests.Form 8308 is filed with Form 1065 for the taxyear that includes the last day of the calendaryear in which the exchange took place. If no-

FairAdjusted Market

Assets Basis Value

Cash ........................................ $10,000 $10,000Accounts receivable ................ 5,000 2,500Trade notes receivable ........... 2,000 2,100Merchandise on hand ............. 4,000 9,500Land ........................................ 80,000 100,000

Total assets ............................. $101,000 $124,100

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tified of an exchange after filing Form 1065,the partnership must file Form 8308 sepa-rately, within 30 days of the notification.

On Form 8308, the partnership states thedate of the exchange and the names, ad-dresses, and taxpayer identification numbersof the partnership filing the return and thetransferee and transferor in the exchange.The partnership must also provide a copy ofForm 8308 (or a written statement with thesame information) to each transferee andtransferor by the later of January 31 followingthe end of the calendar year or 30 days afterit receives notice of the exchange.

The partnership may be subject to a pen-alty of up to $50 for each failure to timely fileForm 8308 and a $50 penalty for each failureto furnish a copy of Form 8308 to a transferoror transferee, unless the failure is due toreasonable cause and not willful neglect. Ifthe failure is intentional, a higher penalty maybe imposed. See the form instructions fordetails.

Statement required of partner. If a partnersells or exchanges any part of an interest ina partnership having unrealized receivablesor inventory (substantially appreciated inven-tory if the sale or exchange was before Au-gust 6, 1997), he or she must file a statementwith his or her tax return for the year in whichthe sale or exchange occurs. The statementmust contain the following information.

1) The date of the sale or exchange, thepartner's adjusted basis for the partner-ship interest, and the part of the basisthat represents the unrealized receiv-ables or inventory items.

2) The money and fair market value of anyother property the partner received orwill receive for the interest in the part-nership, and the part for the unrealizedreceivables or inventory items.

3) The statement described earlier in Spe-cial adjustment to basis of property re-ceived under Partner's Basis for Distrib-uted Property, if the partner computesthe basis for the unrealized receivablesor inventory items under that provision.

4) If the partnership used the optional basisadjustment, the computation describedlater under Adjusting the Basis of Part-nership Property and a list of the part-nership properties to which the adjust-ment has been allocated.

Partner's disposition of distributed unre-alized receivables or inventory items. Ingeneral, any gain or loss on a sale or ex-change of unrealized receivables or inventoryitems a partner receives in a distribution isan ordinary gain or loss. For this purpose,inventory items do not include real or depre-ciable business property, even if they are notheld more than 1 year.

Exception for inventory items heldmore than 5 years. If a distributee partnersells inventory items held for more than 5years after the distribution, the type of gainor loss depends on how they are being usedon the date sold. The gain or loss is capitalgain or loss if the property is a capital assetin the partner's hands at the time sold.

Example 1. Ann receives, through dis-solution, inventory that has a basis of$19,000. Within 5 years, she sells the inven-tory for $24,000. The $5,000 gain is taxed asordinary income. If she had held the inventory

for more than 5 years, her gain would havebeen capital gain, provided the inventory wasa capital asset in her hands at the time ofsale.

Example 2. Mike, a distributee partner,received his share of accounts receivablewhen his law firm dissolved. The partnershipused the cash method of accounting, so thereceivables had a basis of zero to Mike. If thereceivables are later collected, or if Mike sellsthem, the amount received will be ordinaryincome. The 5-year rule, illustrated in Exam-ple 1, does not apply to accounts receivable.

Substituted basis property. If adistributee partner disposes of unrealizedreceivables or inventory items in a nonrecog-nition transaction, ordinary gain or loss treat-ment applies to a later disposition of anysubstituted basis property resulting from thetransaction.

Distributive Share in Yearof DispositionIf a partner disposes of his or her entire in-terest in a partnership, the partner must in-clude his or her distributive share of partner-ship items in income for the tax year in whichmembership in the partnership ends. Tocompute the distributive share of these items,the partnership's tax year is consideredended on the date the partner disposed of theinterest. To avoid an interim closing of thepartnership books, the partners can agree toestimate the distributive share by taking theprorated amount the partner would have in-cluded in income if he or she had remaineda partner for the entire partnership tax year.

A partner who sells or exchanges only partof an interest in a partnership, or whose in-terest is reduced (whether by entry of a newpartner, partial liquidation of a partner's inter-est, gift, or otherwise), reports his or her dis-tributive share of partnership items by takinginto account his or her varying interests dur-ing the partnership year.

Example. ABC is a calendar year part-nership with three partners, Alan, Bob, andCathy. Under the partnership agreement,profits and losses are shared in proportion toeach partner's contributions. On January 1the ratio was 90% for Alan, 5% for Bob, and5% for Cathy. On December 1 Bob and Cathyeach contributed additional amounts. Thenew profit and loss sharing ratios were 30%for Alan, 35% for Bob, and 35% for Cathy.For its tax year ended December 31, thepartnership had a loss of $1,200. This lossoccurred equally over the partnership's taxyear. The loss is divided among the partnersas follows:

Certain cash basis items prorated daily.If any partner's interest in a partnershipchanges during the tax year, each partner'sshare of certain cash basis items of the part-nership must be determined by prorating the

items on a daily basis. That daily portion isthen allocated to the partners in proportion totheir interests in the partnership at the closeof each day. This rule applies to the followingitems for which the partnership uses the cashmethod of accounting.

1) Interest.

2) Taxes.

3) Payments for services or for the use ofproperty.

Deceased partner. If a partner dies, thepartner's estate or other successor in interestreports on its return the decedent's distribu-tive share of the partnership items for thepartnership year ending after the death oc-curred.

For example, if the partnership and thepartners all use the calendar year as their taxyear and one of the partners dies on June 10,none of the income of the partnership for thatyear will be reported on the final return of thedeceased partner. All of it will be included onthe return of the partner's estate or othersuccessor in interest.

However, if the partnership terminateswith the death of a partner, the partnershipyear closes for all partners. The deceasedpartner's share of income for that year will beincluded in the deceased partner's final re-turn. If the decedent's tax year is differentfrom the partnership's, the decedent's finalreturn will include his or her share of part-nership items for the partnership year endingwith the decedent's death and any partner-ship year ending earlier in the decedent's lasttax year.

CAUTION!

For partnership years beginning after1997, the partnership's tax yearcloses with respect to a partner

whose entire interest terminates by death.The decedent's distributive share of the part-nership items for the partnership year inwhich the death occurred are reported on thedecedent's final return. The distributive shareis figured as if for a partner who otherwisedisposes of his or her entire interest in apartnership, as described at the beginning ofthis discussion.

Self-employment income. A differentrule applies in computing a deceased part-ner's self-employment income. Self-employment income of a partner includes thepartner's distributive share of income earnedby the partnership through the end of themonth in which the partner's death occurs.This is true even though the deceased part-ner's estate or heirs may succeed to the de-cedent's rights in the partnership. For thispurpose, partnership income for the year inwhich a partner dies is considered to beearned equally in each month.

Example. Larry, a partner in WoodsPar,is a calendar year taxpayer. WoodsPar's fis-cal year ends June 30. For the partnershipyear ending June 30, 1997, Larry's distribu-tive share of partnership profits is $2,000. OnAugust 18, 1997, Larry dies. For the partner-ship year ending June 30, 1998, Larry andhis estate's distributive share is $3,000.

Larry's self-employment income to be re-ported on Schedule SE (Form 1040) for 1997is $2,500. This consists of his $2,000 distrib-utive share for the partnership tax year endingJune 30, 1997, plus $500 (2/12 × $3,000) of thedistributive share for the tax year ending June30, 1998.

Profit Partor Loss of Year Total Share

Partner % × Held × Loss = of Loss

Alan ............... 90 × 11/12 × $1,200 = $99030 × 1/12 × 1,200 = 30

Bob ................ 5 × 11/12 × 1,200 = 5535 × 1/12 × 1,200 = 35

Cathy ............. 5 × 11/12 × 1,200 = 5535 × 1/12 × 1,200 = 35

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However, Larry's partnership income tobe reported on Form 1040 for 1997 is $2,000.This is because his final return includes onlyhis share of partnership income for the part-nership year that ended within his last taxyear.

Adjusting the Basis ofPartnership PropertyGenerally, a partnership cannot adjust thebasis of its property because of a distributionof property to a partner or because of atransfer of an interest in the partnership,whether by sale or exchange or because ofthe death of a partner. The partnership canadjust the basis only if it files an election tomake an optional adjustment to the basis ofits property upon the distribution or transfer.A partnership does not adjust the basis ofpartnership property for a contribution ofproperty, including money, to the partnership.

Distributions. When there is a distributionof partnership property to a partner, the part-nership makes the optional adjustment by:

1) Increasing the adjusted basis of the re-tained partnership property by:

a) Any gain recognized by thedistributee partner on the distribu-tion, plus

b) The excess, if any, of the partner-ship's adjusted basis for the distrib-uted property (immediately beforethe distribution) over the basis ofthe property to the distributee, or

2) Decreasing the adjusted basis of the re-tained partnership property by:

a) Any loss recognized by thedistributee partner on the distribu-tion, plus

b) The excess, if any, of the distributeepartner's basis for the distributedproperty over the partnership's ad-justed basis for the property (im-mediately before the distribution).

Timing of adjustment. If a partnershipcompletely liquidates the interest of a partnerby making a series of cash payments treatedas distributions of the partner's interest inpartnership property, the basis adjustmentsto partnership property must correspond intiming and amount with the recognition of gainor loss by the retiring partner, or a deceasedpartner's successor in interest, with respectto those payments.

Example. Alan owns a one-third interestin the partnership Sylvan Associates. Sylvanhas an optional adjustment to basis electionin effect. When Alan retires, Sylvan continueswithout dissolution and agrees to liquidateAlan's one-third interest in the partnershipproperty by making a series of cash paymentsto Alan that are treated as distributions. Thetotal amount of payments Alan will receive isfixed and exceeds the adjusted basis ofAlan's interest in the partnership.

Sylvan increases the adjusted basis of itsproperty by Alan's recognized gain in each

partnership tax year during which Alan re-cognizes gain with respect to the payments.

Transfers. When there is a transfer of apartnership interest because of a sale or ex-change or a partner's death, the partnershipmakes the optional adjustment by:

1) Increasing the adjusted basis of thepartnership property by the excess of:

a) The transferee's basis for his or herpartnership interest, over

b) The transferee's share of the ad-justed basis of all partnership prop-erty, or

2) Decreasing the adjusted basis of part-nership property by the excess of:

a) The transferee partner's share ofthe adjusted basis of all partnershipproperty, over

b) The transferee's basis for his or herpartnership interest.

These adjustments affect the basis ofpartnership property for the transferee partneronly. They become part of his or her shareof the common partnership basis.

Making the election. The optional adjust-ment to basis is made by filing a writtenstatement with Form 1065 for the tax year inwhich the distribution or transfer occurs. Forthe election to be valid, the return must befiled on time, including extensions. Thestatement must include the name and ad-dress of the partnership, be signed by one ofthe partners, and state that the partnershipelects under section 754 to apply sections734(b) and 743(b) of the Internal RevenueCode. Once a valid election has been made,it applies in succeeding years until it is re-voked.

If the election cannot be made with thereturn, a partner or the partnership can re-quest an automatic extension of 12 monthsto make the election. See section301.9100–1T through 301.9100–3T of theTemporary Procedure and AdministrationRegulations for more information.

Revoking the election. The election can berevoked only with the approval of the IRS. Anapplication to revoke the election must befiled with the director for the district in whichthe partnership return must be filed. This ap-plication must be filed within 30 days after theclose of the partnership tax year for which thechange is to be effective. The applicationmust be signed by one of the partners andstate why the partnership wishes to revokethe election.

Examples of sufficient grounds for ap-proving the application include:

1) A change in the nature of the business.

2) A substantial increase in assets.

3) A change in the character of the assets.

4) An increased frequency of retirementsor shifts of partnership interests.

However, the IRS will not approve an ap-plication to revoke the election if its primarypurpose is to avoid decreasing the basis ofpartnership assets upon a transfer or distri-bution.

Form 1065ExampleThis filled-in Form 1065 is for the AbleBakerBook Store, a partnership composed of FrankAble and Susan Baker. The partnership usesan accrual method of accounting and a cal-endar year for reporting income and loss.Frank works full time in the business, whileSusan works approximately 25% of her timein it. Both partners are general partners.

The partnership agreement states thatFrank will receive a yearly guaranteed pay-ment of $20,000 and Susan will receive$5,000. Any profit or loss will be sharedequally by the partners. The partners arepersonally liable for all partnership liabilities.Both partners materially participate in the op-eration of the business.

In addition to income and expenses frompartnership operations, AbleBaker made a$650 cash charitable contribution, received$150 from dividends, and received $50 tax-exempt interest from municipal bonds.

Each partner's distributive share of spe-cially allocated items should be shown on theappropriate line of the partner's Schedule K–1and the total amount on Schedule K, insteadof on page 1, Form 1065, or Schedule A orD.

Frank completes the partnership's Form1065 as explained next.

Page 1The IRS sent Frank a postcard with his pre-addressed label asking if he needed a Form1065 package. He returned the postcard andthe IRS sent him the package. When Frankcompletes the return, he places the label inthe address area on page 1.

Frank supplies all the information re-quested at the top of the page.

IncomeThe partnership's ordinary income (loss) fromthe trade or business activity is shown onlines 1a through 8.

Line 1. Gross sales of $409,465 are en-tered on line 1a. Returns and allowances of$3,365 are entered on line 1b, resulting in netsales of $406,100, entered on line 1c.

Line 2. Cost of goods sold, $267,641,from Schedule A, line 8, is entered here.

Line 3. Gross profit of $138,459 is shownon this line.

Line 7. Interest income on accountsreceivable, $559, is entered on this line. Theschedule that must be attached for this lineis not shown.

Line 8. Total income, $139,018 (lines 3through 7), is shown on line 8.

DeductionsThe partnership's allowable deductions areshown on lines 9 through 21.

Line 9. All salaries and wages are in-cluded on line 9, except guaranteed pay-ments to partners (shown on line 10). Franklists $29,350 on line 9. The partnership hadno employment credits to reduce that amount.

Line 10. Guaranteed payments of$25,000 to partners Frank ($20,000) andSusan ($5,000) are entered here.

Page 18

Line 11. Repairs of $1,125 made topartnership equipment are entered on thisline.

Line 12. During the year, $250 owed tothe partnership was determined to be a whollyworthless business bad debt. The $250 isshown on line 12. If this had been a non-business bad debt, it would be included in thepartnership's separately stated short-termcapital loss.

Line 13. Rent paid for the businesspremises, $20,000, is listed on this line.

Line 14. Deductible taxes of $3,295 areentered on this line.

Line 15. Interest paid to suppliers duringthe year totaled $1,451. This is business in-terest, so it is entered on line 15. Interest paidto a partner that is not a guaranteed paymentis also included on this line.

Lines 16a and 16c. Depreciation of$1,174 claimed on assets used in a trade orbusiness is entered on these lines. Line 16bis for depreciation listed elsewhere on thereturn. Form 4562 is not shown in this exam-ple.

Line 20. Other allowable deductions of$8,003 not listed elsewhere on the return andfor which a separate line is not provided onpage 1 are included on this line. Frank at-taches a schedule that lists each deductionand the amount included on line 20. Thisschedule is not shown.

Line 21. The total of all deductions,$89,648 (lines 9 through 20), is entered onthis line.

Line 22. The amount on line 21 is sub-tracted from the amount on line 8. The result,$49,370, is entered on line 22 of page 1 andon line 1 of Schedule K. The amount allocatedto each partner is listed on line 1 of ScheduleK–1.

SignaturesFrank signs the return as a general partner.The AbleBaker Book Store did not have apaid preparer.

Page 2Schedule ASchedule A shows the computation of costof goods sold. Beginning inventory, $18,125,is entered on line 1 and net purchases,$268,741, are entered on line 2. The total,$286,866, is entered on line 6. Ending in-ventory, $19,225 (entered on line 7), is sub-tracted from line 6 to arrive at cost of goodssold, $267,641 (entered on line 8 and on page1, line 2).

Frank answers all applicable questions foritem 9.

Schedule BSchedule B contains 11 questions about thepartnership. Frank answers question 1 bymarking the “General partnership” box. Heanswers questions 2 through 11 by markingthe “No” boxes.

Question 5 asks if the partnership meetsall the requirements listed in items 5a, b, andc. Because the partnership's total receiptswere not less than $250,000, all three ofthese requirements are not met. Frank mustcomplete Schedules L, M–1, M–2, and itemF on page 1 of Form 1065 and item J onSchedule K–1.

Pages 3 – 4Schedule KSchedule K lists the total of all partners'shares of income, deductions, credits, etc.Each partner's distributive share of income,deductions, credits, etc., is reported onSchedule K–1. The line items for Schedule Kare discussed in combination with theSchedule K–1 line items, later.

Page 4—Analysis of Net Income(Loss)An analysis must be made of the distributiveitems on Schedule K. This analysis is basedon the type of partner. Since the AbleBakerBook Store has two individual partners, bothof whom are “active” general partners, thetotal, $73,870, on line 1 is entered on line 2a,column ii.

Page 4Schedules L, M–1, and M–2Partnerships do not have to completeSchedules L, M–1, or M–2 if all of the testslisted under question 5 of Schedule B are metand question 5 is marked “Yes.” TheAbleBaker Book Store does not meet all ofthe tests, so these schedules must be com-pleted.

Schedule LSchedule L contains the partnership's bal-ance sheets at the beginning and end of thetax year. All information shown on the bal-ance sheets for the AbleBaker Book Storeshould agree with its books of record.

The entry in column (d) of line 14 for totalassets at the end of the year, $45,391, iscarried to item F at the top of page 1 since theanswer to question 5 on Schedule B was“No.”

Schedule M–1Schedule M–1 is the reconciliation of incomeper the partnership books with income perForm 1065.

Line 1. This line shows the net incomeper books of $48,920. This amount is from theprofit and loss account (not shown in this ex-ample).

Line 3. This line shows the guaranteedpayments to partners.

Line 5. This is the total of lines 1 through4 of $73,920.

Line 6. Included in line 6 is the $50 tax-exempt interest income from municipal bondsrecorded on the books but not included onSchedule K, lines 1 through 7. This interestis reported on Schedule K, line 19.

Line 9. This is line 5 less line 8, $73,870.This line is the same as line 1 of the Analysisof Net Income (Loss) section of Schedule Kat the top of page 4.

Schedule M–2Schedule M–2 is an analysis of the partners'capital accounts. It shows the total equity ofall partners at the beginning and end of thetax year and the adjustments that caused anyincrease or decrease. The total of all thepartners' capital accounts is the differencebetween the partnership's assets and liabil-ities shown on Schedule L. A partner's capitalaccount does not necessarily represent thetax basis for an interest in the partnership.

Line 1. As of January 1, the total of thepartners' capital accounts was $27,550(Frank — $14,050; Susan — $13,500). Thisamount should agree with the beginning bal-ance shown on line 21 of Schedule L for thepartners' capital accounts.

Line 3. This is the net income per books.Line 5. This is the total of lines 1 through

4.Line 6. Each partner withdrew $26,440

(totaling $52,880) from the partnership. Thesewithdrawals are shown here and on ScheduleK, line 22. The partners' guaranteed pay-ments, which were actually paid, are not in-cluded because they were deducted whenfiguring the amount shown on line 3.

Line 9. This shows the total equity of allpartners as shown in the books of record asof December 31. This amount should agreewith the year-end balance shown on line 21of Schedule L for the partners' capital ac-counts.

Item J on Schedule K–1 reflects eachpartner's share of the amounts shown on lines1 through 9 of Schedule M–2.

Schedule K–1Schedule K–1 lists each partner's share ofincome, deductions, credits, etc. It also showswhere to report the items on the partner's in-dividual income tax return. Illustrated is acopy of the Schedule K–1 for Frank W. Able.All information asked for at the top of Sched-ule K–1 must be supplied for each partner.

Allocation ofPartnership ItemsThe partners' shares of income, deductions,etc., are shown next.

Income (Loss)Line 1. This line on Schedule K–1 shows

Frank's share ($24,685) of the income fromthe partnership shown on Form 1065, page1, line 22. The total amount of income to bothpartners is shown on line 1, Schedule K.

Line 4b. Dividends must be separatelystated. They are not included in the income(loss) of the partnership on Form 1065, page1, line 22. This line on Schedule K–1 showsFrank's share, $75. This line on Schedule Kshows the total dividends of $150.

Line 5. This line on Schedule K–1 showsonly the guaranteed payments to Frank of$20,000. This line on Schedule K shows thetotal guaranteed payments to both partnersof $25,000.

DeductionsLine 8. During the year, the partnership

made a $650 cash contribution to the Ameri-can Lung Association. Each partner may beable to deduct his or her share of the part-nership's charitable contribution on his or herindividual income tax return if the partneritemizes deductions. Frank's share of thecontribution, $325, is entered on line 8,Schedule K–1. This line on Schedule K showsthe total contribution.

Investment InterestLines 14a–14b. The partnership had in-

vestment income (dividends) of $150 asshown on line 4b, Schedule K. This amountis shown on line 14b(1), Schedule K, and thepartner's share is shown on line 14b(1),Schedule K–1.

Page 19

Net Earnings FromSelf-Employment

Line 15a. Net earnings (loss) from self-employment are figured using the worksheetin the Form 1065 instructions for Schedule K(not shown). Frank and Susan's net earningsfrom self-employment are the total of thepartnership income shown on line 1 ofSchedule K and the guaranteed paymentsshown on line 5. This total, $74,370, is en-tered on Schedule K, and each individual

partner's share is shown on his or herSchedule K–1. Each partner uses his or hershare to figure his or her self-employment taxon Schedule SE (Form 1040), Self-Employment Tax (not shown).

Tax-Exempt Interest IncomeLine 19. Tax-exempt interest income, in-

cluding any exempt-interest dividends re-ceived from a mutual fund or other regulatedinvestment company, is entered here. Frank

enters the $50 municipal bond interest re-ceived by the partnership on Schedule K and$25 on each partner's Schedule K–1.

DistributionsLine 22. Frank enters the $52,880 cash

withdrawals made by the partners during theyear on Schedule K. He enters the amounteach partner withdrew on the partner'sSchedule K–1.

Page 20

Retail

Books

5942 45,391

10-1-79

2u

409,4653,365 406,100

267,641138,459

559

139,018

29,35025,000

1,125250

20,0003,295

1,451

1,174

8,003

89,648

49,370

1,174– 0 –

Frank W. Able 3-12-98

10-9876543AbleBaker Book Store334 West Main StreetOrange, MD 20904

DEC97

OMB No. 1545-0099U.S. Partnership Return of Income1065FormDepartment of the TreasuryInternal Revenue Service © See separate instructions.

A Principal business activity D Employer identification numberUse theIRSlabel.Other-wise,pleaseprintor type.

Principal product or serviceB E Date business started

Business code numberC F Total assets(see page 10 of the instructions)

$

Final return(2)Initial return(1)Check applicable boxes:G (3) Change in address (4) Amended return

Accrual(2)Cash(1)Check accounting method:H (3) Other (specify) ©

Number of Schedules K-1. Attach one for each person who was a partner at any time during the tax year ©I

Caution: Include only trade or business income and expenses on lines 1a through 22 below. See the instructions for more information.

1aa1 Gross receipts or sales1c1bb Less returns and allowances

22 Cost of goods sold (Schedule A, line 8)33 Gross profit. Subtract line 2 from line 1c4Ordinary income (loss) from other partnerships, estates, and trusts (attach schedule)4

Inco

me

55 Net farm profit (loss) (attach Schedule F (Form 1040))66 Net gain (loss) from Form 4797, Part II, line 18

77 Other income (loss) (attach schedule)

8 Total income (loss). Combine lines 3 through 7 8

9 Salaries and wages (other than to partners) (less employment credits)10Guaranteed payments to partners1011

Rent13

12

Interest15

13

Taxes and licenses14 14

Bad debts12

15

Repairs and maintenance11

16aDepreciation (if required, attach Form 4562)16a16c16bLess depreciation reported on Schedule A and elsewhere on returnb17Depletion (Do not deduct oil and gas depletion.)17

1918 Retirement plans, etc.

Employee benefit programs

21

19

Other deductions (attach schedule)

Ded

ucti

ons

(see

pag

e 11

of t

he in

stru

ctio

ns fo

r lim

itatio

ns)

Total deductions. Add the amounts shown in the far right column for lines 9 through 20

20 20

Ordinary income (loss) from trade or business activities. Subtract line 21 from line 8

21

22Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledgeand belief, it is true, correct, and complete. Declaration of preparer (other than general partner or limited liability company member) is based on allinformation of which preparer has any knowledge.Please

SignHere DateSignature of general partner or limited liability company member

Preparer’s social security no.DatePreparer’ssignature Check if

self-employed ©PaidPreparer’sUse Only Firm’s name (or

yours if self-employed)and address

Form 1065 (1997)For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11390Z

©

18

22

©

©

© EIN ©

ZIP code ©

For calendar year 1997, or tax year beginning , 1997, and ending , 19 .

9

1997I

R

S

Page 21

18,125268,741

– 0 –– 0 –– 0 –

286,86619,225

267,641

uu

u

u

u

u

u

uuu

u

u

u

u

Form 1065 (1997) Page 2

Cost of Goods Sold (see page 13 of the instructions)

11 Inventory at beginning of year22 Purchases less cost of items withdrawn for personal use33 Cost of labor44 Additional section 263A costs (attach schedule)55 Other costs (attach schedule)66 Total. Add lines 1 through 577 Inventory at end of year88 Cost of goods sold. Subtract line 7 from line 6. Enter here and on page 1, line 2

9a Check all methods used for valuing closing inventory:

Lower of cost or market as described in Regulations section 1.471-4(ii)Cost as described in Regulations section 1.471-3(i)

(iii)

Check this box if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970) ©cNod Do the rules of section 263A (for property produced or acquired for resale) apply to the partnership?NoYese Was there any change in determining quantities, cost, or valuations between opening and closing inventory?

If “Yes,” attach explanation.

Other Information

Designation of Tax Matters Partner (see page 15 of the instructions)Enter below the general partner designated as the tax matters partner (TMP) for the tax year of this return:

Identifyingnumber of TMP

Name of designated TMP

Address of designated TMP

Other (specify method used and attach explanation) ©

Yes

©

NoYes

8 Has this partnership filed, or is it required to file, Form 8264, Application for Registration of a Tax Shelter?

1

At any time during calendar year 1997, did the partnership have an interest in or a signature or other authorityover a financial account in a foreign country (such as a bank account, securities account, or other financialaccount)? See page 14 of the instructions for exceptions and filing requirements for Form TD F 90-22.1. If “Yes,”enter the name of the foreign country. ©

9

Are any partners in this partnership also partnerships?2Is this partnership a partner in another partnership?3Is this partnership subject to the consolidated audit procedures of sections 6221 through 6233? If “Yes,” seeDesignation of Tax Matters Partner below

4

Does this partnership meet ALL THREE of the following requirements?5

10

Does this partnership have any foreign partners?67 Is this partnership a publicly traded partnership as defined in section 469(k)(2)?

Schedule A

Schedule B

© ©

Was there a distribution of property or a transfer (e.g., by sale or death) of a partnership interest during the taxyear? If “Yes,” you may elect to adjust the basis of the partnership’s assets under section 754 by attaching thestatement described under Elections Made By the Partnership on page 5 of the instructions

11

During the tax year, did the partnership receive a distribution from, or was it the grantor of, or transferor to, aforeign trust? If “Yes,” the partnership may have to file Form 3520 or 926. See page 14 of the instructions

bc

a The partnership’s total receipts for the tax year were less than $250,000;The partnership’s total assets at the end of the tax year were less than $600,000; ANDSchedules K-1 are filed with the return and furnished to the partners on or before the due date (includingextensions) for the partnership return.If “Yes,” the partnership is not required to complete Schedules L, M-1, and M-2; Item F on page 1 of Form 1065;or Item J on Schedule K-1

What type of entity is filing this return? Check the applicable box:General partnership Limited partnership Limited liability company

b Check this box if there was a writedown of “subnormal” goods as described in Regulations section 1.471-2(c) ©

a bOther (see page 14 of the instructions) ©

cd

Page 22

49,370

150

25,000

650

150

74,370

50

52,880

Page 3Form 1065 (1997)

Partners’ Shares of Income, Credits, Deductions, etc.(a) Distributive share items (b) Total amount

Ordinary income (loss) from trade or business activities (page 1, line 22)1 1

Net income (loss) from rental real estate activities (attach Form 8825)2 23aGross income from other rental activities3a

Expenses from other rental activities (attach schedule)b 3b

Net income (loss) from other rental activities. Subtract line 3b from line 3ac 3c

Portfolio income (loss):44a

Dividend incomeb 4b

Royalty incomec 4c4dNet short-term capital gain (loss) (attach Schedule D (Form 1065))d

Inco

me

(Los

s)

4e(2)Net long-term capital gain (loss) (attach Schedule D (Form 1065)):e

4fOther portfolio income (loss) (attach schedule)f5Guaranteed payments to partners5

6bNet section 1231 gain (loss) (other than due to casualty or theft) (attach Form 4797):6

7Other income (loss) (attach schedule)7

8Charitable contributions (attach schedule)89Section 179 expense deduction (attach Form 4562)9

10Deductions related to portfolio income (itemize)10

Ded

uc-

tions

Other deductions (attach schedule)11 11

14a14a Interest expense on investment debts14b(1)(1)b Investment income included on lines 4a, 4b, 4c, and 4f above

Inve

st-

men

tIn

tere

st

14b(2)(2) Investment expenses included on line 10 above

12a Low-income housing credit:12a(1)(1) From partnerships to which section 42(j)(5) applies for property placed in service before 199012a(2)(2) Other than on line 12a(1) for property placed in service before 199012a(3)(3) From partnerships to which section 42(j)(5) applies for property placed in service after 198912a(4)(4) Other than on line 12a(3) for property placed in service after 1989

Cre

dits

12bQualified rehabilitation expenditures related to rental real estate activities (attach Form 3468)b12cCredits (other than credits shown on lines 12a and 12b) related to rental real estate activitiesc12dCredits related to other rental activitiesd

Other credits13 13

15aNet earnings (loss) from self-employment15a15bGross farming or fishing incomeb

Self-

Empl

oy-

men

t

c Gross nonfarm income 15c16a16a16bb16c

Depreciation adjustment on property placed in service after 1986

cd

Depletion (other than oil and gas)16d(1)Gross income from oil, gas, and geothermal properties(1)

e16d(2)Deductions allocable to oil, gas, and geothermal properties(2)

Adju

stm

ents

and

Tax

Pref

eren

ceIte

ms

Other adjustments and tax preference items (attach schedule)

Type of income ©17a

17cTotal gross income from sources outside the United States (attach schedule)c17dTotal applicable deductions and losses (attach schedule)d17eTotal foreign taxes (check one): © Paid Accruede17fReduction in taxes available for credit (attach schedule)fFo

reig

n Ta

xes

Other foreign tax information (attach schedule)g 17g

18b18 Section 59(e)(2) expenditures: a Type © b Amount ©

Oth

er

24 Other items and amounts required to be reported separately to partners (attach schedule)

Schedule K

Adjusted gain or loss

16e

192021

Tax-exempt interest incomeOther tax-exempt incomeNondeductible expenses

192021

Distributions of money (cash and marketable securities)Distributions of property other than money

2223

2223

Interest incomea

(1)

a

28% rate gain (loss) ©

28% rate gain (loss) ©

(2) Total for year ©

b Total for year ©

b Name of foreign country or U.S. possession ©

Page 23

3,455 3,3507,150 10,990

7,150 10,99018,125 19,225

1,000 1,000

1,000 1,00015,00015,000

4,000 11,000 5,174

41,730 45,391

10,180 10,4624,000 3,600

7,739

27,550 23,59041,730 45,391

48,920

25,000

73,920

27,550

48,920

76,470

50

50

50

73,870

52,880

52,88023,590

9,826

Page 4Form 1065 (1997)

Balance Sheets per Books (Not required if Question 5 on Schedule B is answered “Yes.”)Beginning of tax year End of tax year

Assets (d)(c)(b)(a)

1 Cash2a Trade notes and accounts receivable

b Less allowance for bad debts3 Inventories4 U.S. government obligations

Tax-exempt securities5Other current assets (attach schedule)6Mortgage and real estate loans7Other investments (attach schedule)8Buildings and other depreciable assets9aLess accumulated depreciationbDepletable assets10aLess accumulated depletionbLand (net of any amortization)11Intangible assets (amortizable only)12aLess accumulated amortizationbOther assets (attach schedule)13Total assets14

Liabilities and Capital15 Accounts payable16 Mortgages, notes, bonds payable in less than 1 year17 Other current liabilities (attach schedule)18 All nonrecourse loans19 Mortgages, notes, bonds payable in 1 year or more20 Other liabilities (attach schedule)21 Partners’ capital accounts22 Total liabilities and capital

Reconciliation of Income (Loss) per Books With Income (Loss) per Return(Not required if Question 5 on Schedule B is answered “Yes.” See page 23 of the instructions.)

1 Net income (loss) per books2 Income included on Schedule K, lines 1

through 4, 6, and 7, not recorded on booksthis year (itemize):

4 Expenses recorded on books this year notincluded on Schedule K, lines 1 through11, 14a, 17e, and 18b (itemize):

a Depreciation $b Travel and entertainment $

5 Add lines 1 through 4

6 Income recorded on books this year not includedon Schedule K, lines 1 through 7 (itemize):

a Tax-exempt interest $

7 Deductions included on Schedule K, lines 1through 11, 14a, 17e, and 18b, not chargedagainst book income this year (itemize):

a Depreciation $

8 Add lines 6 and 79 Income (loss) (Analysis of Net Income (Loss),

line 1). Subtract line 8 from line 5Analysis of Partners’ Capital Accounts (Not required if Question 5 on Schedule B is answered “Yes.”)

1 Balance at beginning of year2 Capital contributed during year3 Net income (loss) per books4 Other increases (itemize):

5 Add lines 1 through 4

6 Distributions: a Cashb Property

7 Other decreases (itemize):

8 Add lines 6 and 79 Balance at end of year. Subtract line 8 from line 5

Schedule L

Schedule M-1

Schedule M-2

3 Guaranteed payments (other than healthinsurance)

Net income (loss). Combine Schedule K, lines 1 through 7 in column (b). From the result, subtract thesum of Schedule K, lines 8 through 11, 14a, 17e, and 18b 1

(ii) Individual(active)

Analysis bypartner type:

(v) Exemptorganization

(i) Corporate (iv) Partnership (vi) Nominee/Other

General partners

Analysis of Net Income (Loss)

Limited partners

1

2

ba

(iii) Individual(passive)

73,870

73,870

Page 24

10 9876543123-00-6789

Frank W. Able10 Green StreetOrange, MD 20904

Able Baker Book Store334 West Main StreetOrange, MD 20904

u

50

Philadelphia

10,900N/A

14,050 24,460 26,440

24,685

75

20,000

325

uIndividual

5050

12,070

SCHEDULE K-1 OMB No. 1545-0099Partner’s Share of Income, Credits, Deductions, etc.© See separate instructions.(Form 1065)

For calendar year 1997 or tax year beginning , 1997, and ending , 19Department of the TreasuryInternal Revenue Service

Partnership’s identifying number ©Partner’s identifying number ©

Partnership’s name, address, and ZIP codePartner’s name, address, and ZIP code

(ii) End ofyear

(i) Before changeor termination

limited partnerThis partner is a general partnerA

Enter partner’s percentage of:

F

%

Partner’s share of liabilities (see instructions):

B

Profit sharing

Nonrecourse $

Loss sharing

Qualified nonrecourse financing

Ownership of capital

G Tax shelter registration number ©

OtherWhat type of entity is this partner? ©

C Is this partner a domestic or a foreign partner?D

H Check here if this partnership is a publicly tradedpartnership as defined in section 469(k)(2)

E I Check applicable boxes:

(c) 1040 filers enter theamount in column (b) on:(a) Distributive share item (b) Amount

1Ordinary income (loss) from trade or business activities1 See page 6 of Partner’sInstructions for Schedule K-1(Form 1065).

2Net income (loss) from rental real estate activities23Net income (loss) from other rental activities3

Portfolio income (loss):44a Sch. B, Part I, line 1Interesta4b Sch. B, Part II, line 5Dividendsb4c Sch. E, Part I, line 4Royaltiesc

Net short-term capital gain (loss)dNet long-term capital gain (loss):e

Inco

me

(Los

s)

4f Enter on applicable line of your return.Other portfolio income (loss) (attach schedule)f

See page 6 of Partner’sInstructions for Schedule K-1(Form 1065).

55 Guaranteed payments to partnerNet section 1231 gain (loss) (other than due to casualty or theft):6

Enter on applicable line of your return.Other income (loss) (attach schedule)7 7

Sch. A, line 15 or 168Charitable contributions (see instructions) (attach schedule)89Section 179 expense deduction9 See page 7 of Partner’s

Instructions for Schedule K-1(Form 1065).

10Deductions related to portfolio income (attach schedule)10

Ded

uc-

tions

Other deductions (attach schedule)11 11

Low-income housing credit:12a

a(1)(1) From section 42(j)(5) partnerships for property placed inservice before 1990

a(2)(2) Other than on line 12a(1) for property placed in service before 1990Form 8586, line 5

a(3)(3) From section 42(j)(5) partnerships for property placed inservice after 1989

a(4)(4) Other than on line 12a(3) for property placed in service after 1989Qualified rehabilitation expenditures related to rental real estateactivities

bCre

dits

12b

Credits (other than credits shown on lines 12a and 12b) relatedto rental real estate activities

c See page 8 of Partner’sInstructions for Schedule K-1(Form 1065).

12c

Credits related to other rental activitiesd 12dOther credits13 13

Schedule K-1 (Form 1065) 1997For Paperwork Reduction Act Notice, see Instructions for Form 1065.

%

%

%

$$

%%

%

%%

%

Cat. No. 11394R

%

limited liability company member

IRS Center where partnership filed return: (1) Final K-1 (2) Amended K-1

Analysis of partner’s capital account:J(e) Capital account at end of

year (combine columns (a)through (d))

(d) Withdrawals anddistributions

(a) Capital account atbeginning of year

(c) Partner’s share of lines3, 4, and 7, Form 1065,

Schedule M-2

(b) Capital contributedduring year

( )

1997

4d Sch. D, line 5, col. (f)

(1) 28% rate gain (loss)(2) Total for year

e(1) Sch. D, line 12, col. (g)e(2) Sch. D, line 12, col. (f)

28% rate gain (loss)a 6a

b Total for year 6b

Page 25

75

25

26,440

Page 2Schedule K-1 (Form 1065) 1997

(c) 1040 filers enter theamount in column (b) on:(b) Amount(a) Distributive share item

16a 16a

Adjusted gain or lossb See page 9 of Partner’sInstructionsfor Schedule K-1(Form 1065) andInstructions for Form 6251.

16b16c

Depreciation adjustment on property placed in service after 1986

c Depletion (other than oil and gas)d d(1)

e

(1) Gross income from oil, gas, and geothermal properties

Adju

stm

ents

and

Tax

Pref

eren

ce It

ems

(2) Deductions allocable to oil, gas, and geothermal properties d(2)Other adjustments and tax preference items (attach schedule) 16e

17a Type of income © Form 1116, check boxes

Name of foreign country or possession ©b

Total gross income from sources outside the United States (attachschedule)

c17c

Form 1116, Part I

17dTotal applicable deductions and losses (attach schedule)d17eTotal foreign taxes (check one): © Paid Accruede Form 1116, Part II

Fore

ign

Taxe

s

17fReduction in taxes available for credit (attach schedule)f Form 1116, Part IIIg 17g See Instructions for Form 1116.Other foreign tax information (attach schedule)

See page 9 of Partner’sInstructions for Schedule K-1(Form 1065).18b

18b

Section 59(e)(2) expenditures: a Type ©

Oth

er

Recapture of low-income housing credit:2424aFrom section 42(j)(5) partnershipsa Form 8611, line 8

Other than on line 24ab 24b

25 Supplemental information required to be reported separately to each partner (attach additional schedules if more space isneeded):

Sup

plem

enta

l Inf

orm

atio

n

%

%

%

192021

Tax-exempt interest incomeOther tax-exempt incomeNondeductible expenses

192021

Form 1040, line 8b

See page 9 of Partner’sInstructions for Schedule K-1(Form 1065).

Amount %

22 Distributions of money (cash and marketable securities) 22

23 Distributions of property other than money 23%

Sch. SE, Section A or B15aNet earnings (loss) from self-employment15a15b See page 9 of Partner’s

Instructions for Schedule K-1(Form 1065).

Gross farming or fishing incomeb

Self-

em-

ploy

men

t

Gross nonfarm incomec 15c %

14a14a Interest expense on investment debts Form 4952, line 1

b(1)(1) Investment income included on lines 4a, 4b, 4c, and 4fb See page 8 of Partner’sInstructions for Schedule K-1(Form 1065).(2) Investment expenses included on line 10 b(2)In

vest

men

tIn

tere

st

%44,685

Page 26

How To Get MoreInformation

You can get help from the IRS in severalways.

Free publications and forms. To order freepublications and forms, call 1–800–TAX–FORM (1–800–829–3676). You can alsowrite to the IRS Forms Distribution Centernearest you. Check your income tax packagefor the address. Your local library or post of-fice may also have the items you need.

For a list of free tax publications, orderPublication 910, Guide to Free Tax Services.

It also contains an index of tax topics andrelated publications and describes other freetax services available from the IRS, includingtax education and assistance programs.

If you have access to a personal computerand modem, you can also get many formsand publications electronically. See Quickand Easy Access to Tax Help and Forms inyour income tax package for details.

Tax questions. You can call the IRS withyour tax questions. Check your income taxpackage or telephone book for the localnumber, or you can call 1–800–829–1040.

TTY/TDD equipment. If you have access toTTY/TDD equipment, you can call 1–800–829–4059 to ask tax questions or to orderforms and publications. See your income taxpackage for details.

Evaluating the quality of our telephoneservices. To ensure that IRS representativesgive accurate, courteous, and professionalanswers, we evaluate the quality of our “800number” telephone services in several ways.

1) A second IRS representative sometimesmonitors live telephone calls. That per-son only evaluates the IRS assistor anddoes not keep a record of any taxpayer'sname or tax identification number.

2) We sometimes record telephone calls toevaluate IRS assistors objectively. Wehold these recordings no longer than oneweek and use them only to measure thequality of assistance.

3) We value our customers' opinions.Throughout this year, we will be survey-ing our customers for their opinions onour service.

Index

AActivity not for profit .................... 7

Allocations:Built-in gain or loss .............. 12

Installment sale .................... 15 Interest expense ..................... 8 Nonrecourse liability ............... 6 Partnership items ................. 19

Substantial economic effect ... 6Alternative minimum tax .............. 6

At-risk limits ................................. 7 Audit, consolidated ...................... 7

B Basis, partnership:

Adjusting ............................... 18 Distributions .......................... 18

Election, optional adjustment 18Transfer of interest ............... 18

Built-in gain or loss .................... 12

C Capital interest ...................... 3, 13 Contribution:Basis of property .................. 12Built-in gain or loss .............. 12Distribution of property ......... 13Net precontribution gain ......... 9

Property ................................ 12 Services ................................ 13

D Deceased partner:

Distributive share ................. 17Liquidation of interest ........... 15

Self-employment income ...... 17 Definition, partnership ................. 2 Determining ownership .............. 12 Distributions:Gain or loss ............................ 9Interest expense, loan ............ 8

Partner's debt ......................... 9 Partnership ............................. 8

Distributive share: Adjusted basis ...................... 13

Canceled qualified real propertybusiness debt .................... 7

Character of items .................. 7 Deceased partner ................. 17

Determined by interest in part-nership .............................. 6 Guaranteed payments .......... 11

Limits on losses ..................... 7 Partner's ................................. 6 Reporting ................................ 6 Self-employment tax .............. 6

Year of disposition ............... 17

E Estimated tax ............................... 6

Expenses paid by partner ........... 8

F Family partnership ....................... 3 Form 1065:

Due date ................................. 5 Example ............................... 18 Schedule K–1 ................... 5, 19

Form: 982 ......................................... 7 8082 ....................................... 7 8308 ..................................... 16 8832 ....................................... 2

GGross income, partner ................. 6

Guaranteed payments ............... 11

HHelp from IRS ............................ 27

Husband-wife partnership ........... 3

IInsurance, self-employed health 11Inventory items, substantially ap-

preciated ............................... 16

L Liability:

Assumption of ...................... 14 Nonrecourse ........................... 6

Partner's assumed by partner-ship .................................. 13 Partnership's ........................ 14

Liquidation:

Constructive ......................... 14 Partner's interest .................... 9

Partner's retirement or death 15 Losses:

Limits ...................................... 7Sales or exchanges ............. 12

M Marketable securities .................. 9

N Nonrecourse liability .................... 6 Not-for-profit activity .................... 7

O Organization expenses ................ 6

P Partner's:Alternative minimum tax ......... 6Basis, distributed property ..... 9Basis, partnership interest ... 13

Distributive share ................... 6 Estimated tax ......................... 6 Interest:Acquired by gift ............... 13Alternative rule, adjusted

basis ........................... 14 Basis ............................... 13 Basis adjustments ........... 13 Book value ...................... 14 Liquidation of ............... 9, 15

Mandatory basis adjust-ment ........................... 11

Sale, exchange, transfer . 15Special basis adjustment 10

Transactions with partnership 11 Partnership:Abandoned or worthless inter-

est ................................... 15 Agreement .............................. 3

Basis, contributed property .. 12 Capital interest ....................... 3 Defined ................................... 2

Exclusion from rules ............... 3 Family ..................................... 3 Forming .................................. 2 Husband-wife ......................... 3

Income or loss ........................ 5

Interest ................................... 6 Liabilities ............................... 14 Terminating ............................ 3

Transactions with partner ..... 11 Passive activities ......................... 7 Penalties:

Criminal .................................. 5Failure to file .......................... 5Failure to furnish copy of

Schedule K–1 .................... 5 Other ...................................... 5

Trust fund recovery ................ 5 Precontribution gain .................... 9

Principal partner defined ............. 4Problem Resolution Program ...... 2

Profits interest ........................... 13Publications and forms, free ..... 27

R Related person .......................... 14 Retiring partner .......................... 15

SSection 179 deduction ................. 8Self-employed health insurance 11

Self-employment tax .................... 6Short period return .................. 3, 4Substantial economic effect ........ 6Substantially appreciated inven-

tory items .............................. 16 Syndication fees .......................... 6

TTax withholding, foreign person or

firm ......................................... 1 Tax year:

Business purpose ................... 4 Exceptions .............................. 4 Partner .................................... 4 Partnership ............................. 4 Required ................................. 4

Section 444 election ............... 4Short period return ................. 4

Terminating a partnership ........... 3

U Unrealized receivables .............. 16

�

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