US Internal Revenue Service: p541--1997

8/14/2019 US Internal Revenue Service: p541--1997

1/27

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 property

interest 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

Publica tion 541Cat. No. 15071D

Partnerships

For use in preparing

1997 Returns

Get f orms and other informat ion 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.


2/27

Important Changes for1997

Businesses 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 Propertyunder 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 for1998

Closing 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 Reminders

Unresolved 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 at18008291040 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 call18008294059 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 18887343247.

Useful ItemsYou may want to see:

Publication

505 Tax Withholding and EstimatedTax

533 Self-Employment Tax

535 Business Expenses

537 Installment Sales

538 Accounting Periods and Methods

544 Sales and Other Dispositions ofAssets

551 Basis of Assets

925 Passive Activity and At-Risk Rules

946 How To Depreciate Property

Form (and Instructions)

1065 U.S. Partnership Return of In-

come

Schedule K1 (Form 1065) Partner'sShare of Income, Credits, De-ductions, Etc.

8308 Report of a Sale or Exchange ofCertain Partnership Interests

8582 Passive Activity Loss Limitations

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

8832 Entity Classification Election

See How To Get More Information nearthe end of this publication for information

about 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 termpartnership 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 nota 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 Act

or similar statute.

Many organizations that would meet thesecriteria except that they were formed outsidethe United States are also classified as part-nerships. See section 301.77012 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.

Page 2


3/27

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 if

the 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 had

a 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 loss

from the business on Form 1065. They shouldnotreport 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 K1 (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 1.7081(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 section1.7081(b)(2).

Date of termination. The partnership's taxyear ends on the date of termination. For

purposes 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 distributive

share 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 or

irrevocably 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

Page 3


4/27

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 being

for 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 1.7612(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 less

than 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 that

changes 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 1.7061T.

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 Yearin 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 0.5

Irene . .................... 11/30 0.5 -0- -0-Total Deferral ......................................... 0.5

Page 4


5/27

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 the

calendar 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 K1 due to partners. The part-nership must furnish copies of Schedule K1(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 be

subject 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 K1 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 LossA partnership computes its income and filesits return in the same manner as an individual.However, certain deductions are not allowed

to 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.

Page 5


6/27

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. In

addition, 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) Fil ing 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 DistributiveShareA 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 is

made 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 1.7042 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 of

partnership 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 DistributiveShareA 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

Page 6


7/27

on Schedule K1 (Form 1065). See the Part-ner's Instructions for Schedule K1 (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 each

item 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 his

interest 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 andDeductions

Cancellation 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

Page 7


8/27

that granting relief will not prejudice the in-terests of the government. For more informa-tion on making a late election, see sections301.91001T through 301.91003T 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 of

offsetting 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 Basisunder 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 share

of debt.As explained earlier, however, a partner's

election 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 under

the 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 ScheduleK1) 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 his

or 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 179

property 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 K1. 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.

PartnershipDistributionsPartnership 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.

Page 8


9/27

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

Partner's Gain or LossA 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 received

does 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 fair

market value in (1).For the definition of marketable securities

and 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 orDeathunder 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 partnerun-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 PropertyUnless 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 receives

a 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

Page 9


10/27

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 the

basis 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 appreciation

to 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 the

partnership'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% interest

in 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-

Page 10


11/27

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 mustbe made fora distribution of property, whether or not the

distribution 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 could

not 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 asmoneyunder Partner's Gain or Loss, earlier.The basis increase is allocated among the

securities in proportion to their respectiveamounts of unrealized appreciation before thebasis increase.

Transactions BetweenPartnership andPartnersFor 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 PaymentsGuaranteed 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 K1 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 beforetaking 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 February

1, 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.

Page 11


12/27

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 capital

or 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.

Documents

US Internal Revenue Service: p541--1997