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Chapter 9: Partnership Formation and Operation. Chapter 9: Partnership Formation & Operation. PARTNERSHIP FORMATION & OPERATION (1 of 2). Partnership definitions Overview of partnership taxation Contributions of Property Partnership elections

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Chapter 9: Partnership Formation and Operation

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Chapter 9:Partnership Formation and Operation

Chapter 9:



& Operation


  • Partnership definitions

  • Overview of partnership taxation

  • Contributions of Property

  • Partnership elections

  • Ordinary income/loss vs. separately stated items

  • Partners’ distributive share of items


  • Special allocations

  • Partner’s basis in partnership interest

  • Special loss limitations

  • Guaranteed payments

  • Transactions between partner & partnership

  • Family partnerships

Partnership Definitions(1 of 5)

  • Tax definition of a partnership

    • Syndicate, group, pool, joint venture or other unincorporated organization that carries on a business

Partnership Definitions(2 of 5)

  • General partnership

    • Two or more partners

    • All partners are general partners

      • May participate in mgmt

      • May make commitments on behalf of partnership

      • Unlimited liability for partnership debts

Partnership Definitions(3 of 5)

  • Limited partnership

    • One or more general partners and

    • One of more limited partners

      • Cannot participate in management

      • Cannot make commitments for partnership

      • Liability generally limited to amount invested in partnership

Partnership Definitions(4 of 5)

  • Limited liability companies (LLCs)

    • May be taxed as a partnership or a corp (using check-the-box regs)

    • Allows entity to obtain flow-through and flexibility of partnership allocations while maintaining limited liability of a corp.

Partnership Definitions(5 of 5)

  • Limited liability partnerships(LLPs)

    • Used by many professional organizations

    • May be taxed as a partnership or a corp (using check-the-box regs)

    • Partners not liable for failures in work of other partners or people supervised by other partners

  • Electing large partnership (ELP)

    • Non-service partnerships w/ 100 ptrs

Overview of Partnership Taxation

  • Partnership profits and losses

  • Partner’s Basis

  • Partnership distributions

Partnership Profits and Losses (1 of 2)

  • Partnership files Form 1065

    • Information return with no tax due

  • Partners receive a Form K-1

    • Reports partner’s share of income or loss and separately reported items

Partnership Profits and Losses (2 of 2)

  • Partners include profit or loss and separate items on their individual return (Form 1040 for individuals)

  • Loss limitation

    • Partner’s losses limited to his/her basis in the partnership

    • At-risk rules and passive loss rules also apply

Partner’s Basis

  • Partner’s basis increased by share of partnership earnings, additional contributions, & additional assumption of partnership debt

  • Partner’s basis decreased by losses, distributions, & reduction in partnership debt

Partnership Distributions

  • Payment of money to partner usually tax-free because earnings previously taxed

  • If distributions exceed the partner’s basis, gain may be recognized

Contributions of Property

  • General rule

  • Exceptions to nonrecogntion rule

  • Contributions of services

  • Basis

  • See Topic Review C9-1 for summary

General Rule

  • General rule for property contributions in exchange for partnership interest

    • No gain or loss

    • §721 similar to §351

Exceptions toNonrecognition Rule

  • Gains recognition at time of property contribution

    • Partnership would be investment company if it were incorporated

    • Contribution followed by a distribution resulting in a deemed sale

    • Liabilities assumed by partnership in excess of partner’s basis

Contributions of Services(1 of 2)

  • Contribution of services in exchange for partnership interest

    • Income is FMV of services contributed

Contributions of Services(2 of 2)

  • Partnership deducts or capitalizes FMV of services, depending on the nature of the expense

    • Partnership recognizes gain or loss

      • FMV of services – basis in assets allocated to service partner


  • Partner’s basis in partnership equal to money contributed plus partner’s basis in contributed property plus gain recognized on contribution

  • Partnership’s basis in property is partner’s old basis before contribution

    • Holding period also carries over

Partnership Elections

  • Tax year

    • Must be same as majority partner or partners with a 50% or more interest

    • See Topic Review C9-2

  • Overall accounting method

  • Inventory valuation method

  • Depreciation method

Ordinary Income/Loss vs. Separately Stated Items (1 of 2)

  • Separately stated items

    • Net S-T capital gains and losses

    • Net L-T capital gains and losses

    • §1231 gains and losses

    • Charitable contributions

    • Dividends eligible for DRD

Ordinary Income/Loss vs. Separately Stated Items (2 of 2)

  • Separately stated items (continued)

    • Foreign or possession taxes

    • Tax-exempt interest

    • Any items subject to special allocation

  • Partnership ordinary income/loss

    • All items not separately stated

Partners’ Distributive Share of Items

  • Normally determined by terms of partnership agreement

    • Portion of partnership taxable and nontaxable income partner agreed to report for tax purposes

    • Amount not necessarily same as actual amounts distributed to partner in a particular year

Special Allocations(1 of 2)

  • Pre-contribution gains or losses must be allocated to contributing partner for contributions

Special Allocations(2 of 2)

  • Allocations not related to contributed property must have substantial economic effect

    • Allocations affect partners’ capital accounts, and

    • Partners must make up deficit in capital account upon liquidation of partnership

Partner’s Basis in Partnership Interest (1 of 2)

  • Beginning basis

    • Amount paid for interest OR

    • Basis of property/ services contributed

  • Additions to basis

    • Additional contributions, earnings or assumption of liabilities

  • Reductions result from withdrawals, losses or transfer of liabilities

Partner’s Basis in Partnership Interest (2 of 2)

  • Affect of liabilities on partner basis

    Partner’s basis before liabs

    +Increases in share of ptrshp liabs

    -Decreases in share of ptrshp liabs

    +Ptrshp liabs assumed by this partner

    -This partner’sliabs assumed by ptrshp

    =Partner’s basis in the ptrshp interest

Special Loss Limitations(1 of 2)

  • Loss recognition limitations

    • Partner’s basis in partnership interest

    • Portion of partner’s basis not “at risk”

      • Amount partner would lose should the partnership suddenly become worthless.

Special Loss Limitations(2 of 2)

  • Loss recognition limitations (continued)

    • Designation of partnership interest as a “passive activity”

      • “Passive” losses can only be used to offset “passive” income.

      • Disallowed losses are suspended, and can be used to offset future passive income, or when the passive activity is sold

Transactions Between Partner & Partnership

  • Loss sales

    • No loss deducted on sale of property between a partnership and a  50% owner (direct or indirect)

  • Gain sales

    • Gains on sale of property involving a  50% owner produce ordinary income unless property will be a capital asset in hands of new owner

Guaranteed Payments

  • Always ordinary income to recipient

  • Deductible by the partnership from ordinary income

  • Losses due to guaranteed payments allocated among partners

Family Partnerships(1 of 2)

  • Interest must be a capital interest

    • Partner has right to receive assets if partnership liquidates immediately

  • Capital must be a material income producing factor

  • Family member must be true owner

Family Partnerships(2 of 2)

  • Donor-donee allocations of income

    • Donor must be allocated reasonable compensation for services rendered to partnership

    • Remaining partnership income must be allocated based on relative capital interest

Self-Employment Income

  • Individuals who are partners must pay SE tax on the following income from a partnership:

    • Guaranteed payments

    • Partnership ordinary income or loss

    • All separately stated items, except

      • Capital and §1231 gains/losses, interest, dividends, and rental income

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End of Chapter 9

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