Ea Ea2 Su10 Outline

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STUDY UNIT TEN

PARTNERSHIP OPERATIONS
10.1 Partnership Operations and Partner’s Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . 2

10.2 Distribution of Partnership Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
10.3 Partners Dealing with Their Own Partnership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
A partnership is a business organization other than a corporation, a trust, or an estate, co-owned

by two or more persons and operated for a profit.
The partnership, as an untaxed, flow-through entity, reports taxable income or loss and separately
stated items.
1) When computing his or her personal income tax liability, an individual partner must
consider his or her distributive share of the partnership’s taxable income or loss and
every other separately stated item for the partnership, regardless of whether any
distributions were made from the partnership to the partner.
Nonseparately and separately stated partnership items are currently taxed to the partners, but
distributions are generally received tax-free. You should identify the different loss limitation rules.
1) Partnership inventory and unrealized receivables are very important because they can
trigger ordinary income to one partner when another partner receives a distribution (even
of money).
2) Similarly, precontribution gain must be identified as it can trigger and recharacterize
otherwise unrecognized capital gain.
3) Partnership liability fluctuations also have special significance because they vary the
partners’ bases in their partnership interests and affect treatment of distributions.
4) Be prepared to identify a payment to a partner as a guaranteed payment, as a distributive
share, or in a nonpartner capacity, and the effect of the classification, e.g., a deduction to
the partnership passed through ratably to all partners.
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2 SU 10: Partnership Operations
10.1 PARTNERSHIP OPERATIONS AND PARTNER’S TAXABLE INCOME

Partnership-Incurred Liabilities
1. A partner’s share of partnership liabilities affects the partner’s basis in his or her partnership
interest and can result in increased gain being recognized by the partner. Any increase in a
partner’s share of liabilities increases the partner’s basis. The opposite is true for a decrease in
partnership liabilities.
Recourse Liabilities
a. A liability is a recourse liability if the creditor has a claim against the partnership or any
partner for payment if the partnership defaults.
EXAMPLE 10-1 Recourse Liability

ABC Partnership, a general partnership, purchased a building for $100,000 with a $90,000 mortgage from
XYZ Bank secured by the building. Later, the building is destroyed and becomes worthless. Because ABC
is a general partnership, ABC’s general partners are liable for the debts of the partnership in the event the
partnership is unable to pay. If ABC defaults on the mortgage, XYZ can take legal action against the partners
of ABC to pay the $90,000 debt. Thus, the loan is recourse to the partners of ABC (i.e., the partners bear the
economic risk).
1) Partners generally share recourse liabilities based on their ratio for sharing losses.
a) However, regulations allocate a recourse liability to the partner(s) who would
be liable for it if, at the time, all partnership debts were due, all partnership
assets (including cash) had zero value, and a hypothetical liquidation
occurred.
2) A limited partner cannot share in recourse debt in excess of any of his or her
obligations to make additional contributions to the partnership and any additional
amount(s) that (s)he would actually lose if the partnership could not pay its debt.
Nonrecourse Liabilities
b. The creditor has no claim against the partnership or any partners. At most, the creditor has
a claim against a particular secured item of partnership property.
1) Generally, partners share in nonrecourse liabilities based on their ratio for sharing
profits.
EXAMPLE 10-2 Nonrecourse Liabilities

ABC, LLP, purchased a building for $100,000 with a $90,000 mortgage from XYZ Bank. The loan was
secured by the building itself and no partner made a personal guarantee on the loan. In the event that ABC
defaults and is unable to pay the loan, XYZ’s only option is to foreclose and sell the property. If the property’s
value has decreased and the sale proceeds are insufficient to recover the balance of the loan, XYZ has no
other legal remedy. This is because ABC’s partners have limited liability by being partners in an LLP and are
not generally liable for the debts of the partnership. Thus, the loan is nonrecourse to the partners of ABC
(i.e., the lender bears the economic risk, not the partners).
Partnership Cancellation of Debt

c. In general, if the taxpayer has cancellation of debt income because debt is canceled,
forgiven, or discharged for less than the amount the taxpayer must pay, the amount of
the canceled debt is taxable and the taxpayer must report the canceled debt on the tax
return for the year the cancellation occurs.
SU 10: Partnership Operations 3
Partners’ Capital Accounts

2. A capital account is maintained for each partner at the partnership level.
a. A partner’s initial capital account balance is the fair market value (FMV) of the assets (net
of liabilities) (s)he contributed to the partnership.
b. It is separate from the partner’s AB in his or her partnership interest.
c. The basis in partnership interest is assessed in order to track the tax position of the
investment.
EXAMPLE 10-3 Adjusted Basis of Contributed Property

Taxpayer contributes property that has an adjusted basis of $400 and a fair market value of $1,000.
Taxpayer’s partner contributes $1,000 cash. While each has increased their capital account by $1,000, the
adjusted basis of Taxpayer’s partnership interest is only $400 and the adjusted basis of Taxpayer’s partner’s
partnership interest is $1,000.
Partner’s Taxable Income

3. A partner’s taxable income may be affected by his or her interest in a partnership in several
ways. Examples include
a. His or her distributive share of partnership income and separately stated items
b. Sale of his or her partnership interest
c. Dealings with the partnership (e.g., guaranteed payments)
4. A partner reports his or her distributive share of partnership items for the partnership’s tax year
that ends with or within the partner’s tax year.
Partnership Taxable Income
5. Partnership taxable income is determined in the same way as for individuals except that certain
deductions are not allowed for a partnership, other items are required to be separately stated,
and business interest expense is limited.
Separately Stated Items
6. Each partnership item of income, gain, deduction, loss, or credit that may vary the tax liability
of any partner must be separately stated. Items that must be separately stated include the
following:
a. Section 1231 gains and losses
b. Net STCG and net LTCG or loss from the sale or exchange of capital assets
c. Guaranteed payments
d. Interest and dividend income
e. Royalties
f. Tax-exempt income and related expenses
g. Investment income and related expenses
h. Rental activities, portfolio income, and related expenses
i. Cancellation of debt
j. Recovery items (e.g., prior taxes, bad debts)
k. Charitable contributions
l. Foreign income taxes paid or accrued
m. Depletion on oil and gas wells
n. Section 179 deductions
o. Distributions
p. Qualified items of income, gain, and loss for the qualified business income deduction
Ordinary Income
7. This is all taxable items of income, gain, loss, or deduction that are not separately stated.
a. Ordinary income is different from taxable income, which is the sum of all taxable items,
including the separately stated items and the partnership ordinary income or loss.
1) Ordinary income includes such items as gross profit, administrative expenses, and
employee salaries.
2) Exception: Guaranteed payments are subtracted as expenses for computing
ordinary business income but are separately stated as income to the recipient
partner.
Deductions
8. Certain deductions, e.g., charitable contributions, are disallowed in computing partnership
taxable income. These are items that must be separately stated by the partnership.
a. Each partner may be entitled to a deduction for his or her distributive share of these items
in computing his or her personal tax liability.
Contributions to Employee Retirement Accounts
9. Contributions made by a partnership for its employees under a qualified SEP, SIMPLE IRA,
pension, profit sharing plan, annuity plan, or another deferred compensation plan may be
deducted subject to limitations.
a. Contributions to an employee’s IRA are included in the employee’s salaries and wages.
Partner’s Distributive Share
10. Each partner is taxed on his or her share of partnership income whether or not it is distributed.
a. A partner’s distributive share of any partnership item is allocated by the partnership
agreement as long as the allocation has substantial economic effect, which means the
allocation is not for tax avoidance.
1) For example, allocation of tax-exempt income to one partner and taxable interest
(equal in amount) to another partner in a lower tax bracket has no substantial
economic effect; i.e., it is motivated by tax avoidance.
b. If the partnership agreement does not allocate a partnership item, the item must be
allocated to partners according to their interests in the partnership.
Precontribution Gain or Loss
c. To the extent of gain not recognized on contribution of property to the partnership, gain
or loss subsequently recognized on the sale or exchange of an asset by the partnership
must be allocated to the contributing partner.
1) Postcontribution gain or loss is allocated among partners as distributive shares, i.e.,
as any other gain or loss.
EXAMPLE 10-4 Postcontribution Gain or Loss

Tony and Mary form a partnership as equal partners. Tony contributes cash of $100,000, and Mary
contributes an asset with a basis of $80,000 and a FMV of $100,000. Two years later, the partnership sells
the asset for $110,000. The $30,000 gain ($110,000 selling price – $80,000 basis) is allocated, $25,000 to
Mary [$20,000 precontribution gain + (50% partnership interest × $10,000 postcontribution gain)] and $5,000
to Tony (50% partnership interest × $10,000 postcontribution gain).
d. A partner generally must recognize gain on the distribution of property (other than money)
if the partner contributed appreciated property to the partnership during the 7-year period
before the distribution.
1) The gain recognized is the lesser of the following amounts:
a) The excess of
i) The fair market value of the property received in the distribution, over
ii) The adjusted basis of the partner’s interest in the partnership
immediately before the distribution, reduced (but not below zero) by any
money received in the distribution.
b) The “net precontribution gain” of the partner. This is the net gain the partner
would recognize if all the property contributed by the partner within 7 years of
the distribution and held by the partnership immediately before the distribution
were distributed to another partner other than a partner who owns more than
50% of the partnership.
2) The character of the gain is determined by reference to the character of the net
precontribution gain. This gain is in addition to any gain the partner must recognize
if the money distributed is more than his or her basis in the partnership.
3) Subunit 10.2 has further discussion regarding property distributions.
Character
e. The character of distributive shares of partnership items is generally determined at the
partnership level.
1) Any capital loss (FMV < AB) inherent at contribution is capital loss to the extent of
any loss realized when the partnership disposes of the property. This applies for
5 years after contribution.
2) Partnership gain or loss on inventory and unrealized receivables is ordinary income.
This treatment of the inventory (but not the receivables) disappears 5 years after
contribution.
f. If the size of a partner’s interest in the partnership varies (e.g., by sale, purchase,
exchange, liquidation) during a partnership tax year, the distributive shares of partnership
items must be apportioned on a daily basis.
Elections by Partnership or Partner

11. A few of the elections available to partnerships are made at the partnership level:
a. Partnerships make all elections available (except for those listed in b. below), such as
1) Methods of accounting
2) Computing depreciation
3) Installment method election
4) Expensing intangible drilling and development costs
These elections apply equally amongst all partners; however, no election made by a
partnership has any force or effect with respect to any partner’s nonpartnership interests.
b. Partners make the following elections on the individual income tax return:
1) Deduction or credit of foreign income taxes paid
a) The amount is limited to the partner’s distributive share from the partnership.
2) Treatment of mining and exploration expenditures
3) Basis reduction following discharge of indebtedness
Adjustments to Basis
12. The basis of a partner’s interest in a partnership is adjusted each year for subsequent
contributions of capital, partnership taxable income (loss), separately stated items, variations in
the partner’s share of partnership liabilities, and distributions from the partnership to the partner.
Initial basis
+ Subsequent contributions of capital
+/– Distributive share of partnership ordinary business income (loss)
+ Separately stated taxable and nontaxable income
– Separately stated deductible and nondeductible expenditures
+ Increase in allocable share of partnership liabilities
– Decrease in allocable share of partnership liabilities
– Current-year excess business interest expense
– Share of the adjusted basis of charitable property contributions
and foreign taxes paid or accrued
– Distributions from partnership
= Adjusted basis in partnership interest
EXAMPLE 10-5 Year-End Adjusted Basis

The taxpayer’s ownership and basis in the partnership are 50% and $15,000, respectively, at the beginning
of the year. The partnership has ordinary income of $8,000, made charitable contributions of $3,000, and
made a $5,000 distribution to the taxpayer. The taxpayer’s basis at the end of the year is $12,500 [$15,000
beginning basis + ($8,000 ordinary income × 50% ownership) – ($3,000 charitable contribution × 50%
ownership) – $5,000 distribution].
a. Basis is adjusted for variations in a partner’s allocable share of partnership liabilities during
the year, e.g., by payments on principal.
1) Partner capital accounts are not adjusted for partnership liability variations.
b. Basis is not reduced below zero.
c. Basis is reduced without regard to losses suspended under passive activity loss rules and
at-risk rules.
d. No adjustment to basis is made for guaranteed payments received.
Loss Limits
13. A partnership ordinary loss is a negative balance of taxable income.
Basis Limit
a. A partner’s distributive share of a partnership ordinary loss is allowable as a deduction to
the partner only to the extent of the partner’s AB in his or her interest in the partnership at
the end of the year. Excess loss is deductible in a subsequent year in which AB is greater
than zero.
At-Risk Rules
b. Each partner may deduct only a partnership ordinary loss to the extent (s)he is at risk with
respect to the partnership.
1) The at-risk limits also apply at the partnership level with respect to each partnership
activity.
2) The amount of a partnership loss currently deductible (up to an amount for which the
partnership bears economic risk of loss with respect to each partnership activity) is
allocated to partners as a deductible distributive share.
a) Only partnership liabilities for which a partner is personally liable can be
considered in a partner’s at-risk limit.
c. Passive activity losses are deductible in the current tax year only to the extent of gains
from passive activities (in the aggregate).
1) Partnership ordinary loss is generally passive to a partner unless the partner
materially participates in the partnership activity.
Gift of a Partnership Interest
14. Generally, no gain is recognized upon the gift. However, if partnership liabilities allocable to the
gifted interest exceed the AB of the partnership interest, the donor must recognize gain. No loss
is recognized on the gift.
a. The donee’s basis in the interest is the donor’s basis after adjustment for the donor’s
distributive share of partnership items up to the date of the gift.
b. For purposes of computing a loss on a subsequent sale of the interest by the donee,
the FMV of the interest immediately prior to the gift is used if the FMV of the gifted
partnership interest is lower than the basis at the time of the gift.
Inheritance
15. The tax year of a partnership closes with respect to a partner whose entire interest in the
partnership terminates, whether by death, liquidation, or otherwise.
a. The successor has a FMV basis in the interest.
b. The partnership tax year does not close with respect to the other partners.
EXAMPLE 10-6 Effect of Partnership Liabilities

Ivan acquired a 20% interest in a partnership by contributing property that had an adjusted basis to him of
$8,000 and a $4,000 mortgage. The partnership assumed payment of the mortgage. The basis of Ivan’s
interest is calculated as follows:
Adjusted basis of contributed property $8,000
Minus: Part of mortgage assumed by
other partners (80% × $4,000) 3,200
Basis of Ivan’s partnership interest $4,800
EXAMPLE 10-7 Effect of Partnership Liabilities

If, in Example 10-6, the contributed property had a $12,000 mortgage, the basis of Ivan’s partnership interest
would be zero. The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% ×
$12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership
interest. However, this gain would not increase the basis of his partnership interest.
EXAMPLE 10-8 Adjusted Basis of Partner’s Interest

Enzo contributes to his partnership property that has an adjusted basis of $400 and a fair market value
of $1,000. His partner contributes $1,000 cash. While each partner has increased his capital account by
$1,000, which will be reflected in the partnership’s books, the adjusted basis of Enzo’s interest is only $400
and the adjusted basis of his partner’s interest is $1,000.
EXAMPLE 10-9 Adjusted Basis of Partner’s Interest

Juan and Teresa form a cash-basis general partnership with cash contributions of $20,000 each. Under
the partnership agreement, they share all partnership profits and losses equally. The partnership borrows
$60,000 and purchases depreciable business equipment. This debt is included in the partners’ basis in
the partnership because incurring it creates an additional $60,000 of basis in the partnership’s depreciable
property.
If neither partner has an economic risk of loss in the liability, it is a nonrecourse liability. Each partner’s basis
would include his or her share of the liability: $30,000.
If Teresa is required to pay the creditor if the partnership defaults, she has an economic risk of loss in the
liability. Her basis in the partnership would be $80,000 ($20,000 + $60,000), while Juan’s basis would be
$20,000.
EXAMPLE 10-10 Sale, Exchange, or Other Transfer

Kumar became a limited partner in the ABC Partnership by contributing $10,000 in cash on the formation
of the partnership. The adjusted basis of his partnership interest at the end of the current year is $20,000,
which includes his $15,000 share of partnership liabilities. The partnership has no unrealized receivables or
inventory items.
Kumar sells his interest in the partnership for $10,000 in cash. He had been paid his share of the partnership
income for the tax year. Kumar realizes $25,000 from the sale of his partnership interest ($10,000 cash
payment + $15,000 liability relief). He reports $5,000 ($25,000 realized gain – $20,000 basis) as a capital
gain.
EXAMPLE 10-11 Sale, Exchange, or Other Transfer -- Partner Withdrawal

The facts are the same as in Example 10-10, except Kumar withdraws from the partnership when the
adjusted basis of his interest in the partnership is zero. He is considered to have received a distribution of
$15,000, his liability relief. He reports a capital gain of $15,000.
Reporting Requirements of a Partnership

16. A partnership, as a conduit, is not subject to federal income tax. But it must report information
that includes partnership items of income, loss, deduction, and credit to the IRS.
a. A partnership is required to file an initial return for the first year in which it receives income
or incurs expenditures treated as deductions for federal income tax purposes.
b. Form 1065 is used for the partnership’s information return.
c. Signature by any partner is evidence that the partner was authorized to sign the return.
Only one partner is required to sign the return.
d. Any partnership item that may vary tax liability of any partner is separately stated on
Schedule K.
e. A Schedule K-1 is prepared for each partner and contains the partner’s distributive share
of partnership income and separately stated items to be reported on the partner’s tax
return.
f. There are penalties for not filing correct information returns and/or not furnishing correct
payee statements.
Large Businesses with Gross Receipts of More Than $5 Million and Government Entities
(Average annual gross receipts for the most recent 3 taxable years) IRC 6721 & IRC 6722
Due 01-01-2021 Due 01-01-2022
Time returns thru 12-31-2021 thru 12-31-2022
filed/furnished (inflation adjusted) (inflation adjusted)
Not more than 30 days late $50 per return/ $50 per return/
(by March 30 if the due date is February 28) $565,000 maximum $571,000 maximum
$110 per return/ $110 per return/
31 days late – August 1 $1,696,000 maximum $1,713,000 maximum
After August 1 or Not At All
$3,392,000 maximum $3,426,000 maximum
Intentional Disregard No limitation No limitation
Small Businesses with Gross Receipts $5 Million or Less

(Average annual gross receipts for the most recent 3 taxable years) IRC 6721 & IRC 6722
Due 01-01-2021 Due 01-01-2022
Time returns thru 12-31-2021 thru 12-31-2022
filed/furnished (inflation adjusted) (inflation adjusted)
Not more than 30 days late $50 per return/ $50 per return/
(by March 30 if the due date is February 28) $197,500 maximum $199,500 maximum
31 days late – August 1
$565,000 maximum $571,000 maximum
After August 1 or Not At All
$1,130,500 maximum $1,142,000 maximum
Intentional Disregard No limitation No limitation
g. A partnership return is due (postmark date) on or before the 15th day of the 3rd month
following the close of the partnership’s tax year.
h. Inadequate filing. Penalty is imposed in the amount of the number of persons who were
partners at any time during the year, multiplied by $210 (for 2021 returns filed in 2022)
for each of up to 12 months (including a portion of one) that the return was late or
incomplete.
Partnership Representative
17. The IRC provides for designation of a partnership representative who has sole authority to
commit the partnership to tax and litigation matters.
a. All partnerships must designate a partnership representative who
1) May be a partner in the partnership,
2) Must have a substantial presence in the U.S., and
3) Has sole authority to act on behalf of the partnership for purposes of the new rules.
b. The partnership representative’s exclusive authority also includes acting on the
partnership’s behalf in all matters involving examination of the partnership’s tax return,
conducting administrative practice before the IRS, and conducting matters of litigation
regarding disputed tax adjustments.
1) A partner (other than the designated partnership representative) does not have the
statutory right to notification of an audit or updates on its progress and does not
have the right to participate in the audit or resulting litigation.
2) The partnership representative is designated annually on the partnership’s tax
return, and the effective date is the date of filing the return.
c. A partnership with 100 or fewer partners may opt out of having a partnership
representative as long as all partners are “qualifying partners.”
1) Qualifying partners are individuals, estates of deceased partners, and corporations
(both C and S corporations).
2) If the partnership elects to opt out, the IRS will proceed with an audit of each
individual partner.
d. Affirmative action of electing a partnership representative or opting out must occur on each
year’s tax return.
Consistent Treatment Rules
e. The partner’s treatment of partnership items must be consistent with the treatment of that
item by the partnership in all respects, including the amount, timing, and characterization
of the item.
Reporting for Qualified Business Income Deduction (QBID)
18. In regards to a partnership, the qualified business income (QBI) deduction is determined at the
partner level. To allow partners to correctly figure the deduction on the partner’s Form 1040
return, the partnership must report QBI related items on the partner’s Schedule K-1.
a. Identify each trade or business that is a specified service trade or business (SSTB).
The SSTBs are subject to special limitations, not applicable to the qualified trades or
businesses, and generally include a trade or business where the principal asset is the
reputation or skill of one or more of its employees.
b. The QBI (e.g., income, gain, deduction, and loss) from the trade or businesses.
c. The W-2 wage totals paid to employees by each trade or business.
19. Each partner must report his or her share of items consistently with their treatment on the
partnership return.
20. When a partner dies, his or her distributive share of self-employment income is figured through
the end of the month in which the death occurs.
10.2 DISTRIBUTION OF PARTNERSHIP ASSETS

A distribution is a transfer of value from the partnership to a partner in reference to his or her
interest in the partnership. A distribution may be in the form of money, liability relief, or other property.
A draw is a distribution.
Current Distributions
1. A current (or operating) distribution reduces the partner’s basis in the partnership interest.
a. A decrease in a partner’s allocable share of partnership liabilities is treated as a
distribution of money.
Money Distributions
b. The partnership recognizes no gain on money distributions.
1) A partner recognizes gain only to the extent the distribution (FMV) exceeds the AB in
the partnership interest immediately before the distribution.
a) Gain recognized is capital gain.
b) Basis in the interest is decreased, but not below zero.
c) Loss is not recognized.
Property Distributions
c. Generally, no gain or loss is recognized by the partnership when it distributes property,
including money.
1) Precontribution gain or loss. If property is distributed to a noncontributing partner
within 7 years of contribution, the partnership recognizes gain or loss realized to the
extent of any unrealized gain or loss, respectively, that existed at the contribution
date.
a) Allocate this recognized gain (loss) to the contributing partner.
b) The contributing partner’s basis in his or her partnership interest is increased.
c) Basis in the property is also increased.
d) The distributee has a transferred basis.
2) Disproportionate distributions of unrealized receivables or substantially appreciated
inventory result in gain recognition.
d. The distributee partner generally recognizes gain only to the extent that money (including
liability relief) exceeds his or her AB in his or her partnership interest.
e. The partner’s basis in the distributed property is the partnership’s AB in the property
immediately before distribution, but it is limited to the distributee’s AB in his or her
partnership interest minus any money received in the distribution.
1) When the above limit applies, allocate basis
a) First to unrealized receivables and inventory, up to the partnership’s AB in
them, and
b) Second to other (noncash) property.
2) If the available basis is too small, the decrease (Partnership basis in assets – Basis
in partnership interest) is allocated to the assets. The decrease is allocated by the
following steps:
a) Assign each asset its partnership basis.
b) Calculate the decrease amount.
c) Allocate the decrease first to any assets that have declined in value.
d) Allocate any remaining decrease to the assets based on relative adjusted
basis at this point in the calculation.
EXAMPLE 10-12 Allocation if Available Basis Is Inadequate

Karen has a $6,000 basis in the BK Partnership immediately before receiving a current distribution (there
is no remaining precontribution gain). The distribution consists of $5,000 cash, a computer with a FMV of
$1,500 and a $4,000 basis to the partnership, and a desk with a FMV of $500 and a $1,500 basis to the
partnership. Karen’s basis in the distributed property is determined as follows:
Beginning basis in partnership interest $6,000
Less: Money received (5,000)
Remaining basis to allocate $1,000
Computer Desk
Step 1: Allocate partnership basis to each asset. Partnership basis in assets $ 4,000 $1,500
Step 2: Calculate decrease.
Total partnership basis $5,500
Basis to allocate (1,000)
Decrease amount $4,500
Step 3: Allocate decrease to assets Decline in FMV (2,500) (1,000)
with a decline in FMV. Relative adjusted basis $ 1,500 $ 500
Step 4: Allocate remaining decrease of Remaining decrease (750)* (250)*
$1,000 ($4,500 – $2,500 – $1,000)
based on relative adjusted basis.
Karen’s basis in distributed
property $ 750 $ 250
* $750 = ($1,500 ÷ $2,000) × $1,000
$250 = ($500 ÷ $2,000) × $1,000
f. The partner’s holding period in the distributed property includes that of the partnership.
g. The partner’s basis in his or her ownership interest in the partnership is reduced by the
amount of money and the AB of property received in the distribution.
10.3 PARTNERS DEALING WITH THEIR OWN PARTNERSHIP

The Code recognizes that a partner can engage in property, services, and loan transactions with
the partnership in a capacity other than as a partner, i.e., as an independent, outside third party. The
tax result, in general, is as if the transaction took place between two unrelated persons after arm’s-
length negotiations.
Customary Partner Services
1. When a partner performs services for the partnership that are customarily performed by a
partner, the partner’s return is generally his or her share of profits of the partnership business.
a. A partner’s allocable share of partnership items is the partner’s “compensation” for acting
to perform the normal functions of a partner, e.g., driving the truck and keeping books of
an ice cream vending partnership.
1) It is gross income, not as compensation, but as a distributive share of partnership
income.
2) The value of the services is not deductible by the partnership.
Guaranteed Payments
2. A guaranteed payment (GP) is a payment to a partner for services rendered or capital used that
is determined without regard to the income of the partnership. It is used to distinguish payments
that are a function of partnership income and payments connected with partners acting in a
nonpartner capacity.
a. The services must be a customary function of a partner. They are normal activities of a
partner in conducting partnership business.
b. Fixed amount stated. If the partnership agreement provides for a GP in a fixed amount,
e.g., annual salary amount, the GP amount is the stated amount.
c. Stated minimum amount. The partnership agreement may allocate a share of partnership
income to the partner but guarantee payment of not less than a stated amount to the
partner even if the allocable share is less.
1) If so, the GP amount is any excess of the guaranteed minimum amount over the
distributive share allocable to the partner.
d. For purposes of determining the partner’s gross income, the GP is treated as if made to a
nonpartner.
1) The partner separately states the GP from any distributive share.
2) The payment is always ordinary income to the partner (compensation, interest,
possibly rent).
3) The GP is reported in the recipient partner’s tax year that includes the end of the
partnership tax year (in which the GP was made or deducted by the partnership).
4) Receipt of the GP does not directly affect the partner’s AB in his or her partnership
interest.
e. For purposes of determining deductibility by the partnership, a GP is treated as if made to

a nonpartner.
1) The payment is deductible if it would have been deductible if made to a nonpartner.
2) If the GP exceeds the partnership’s ordinary income, the resulting ordinary loss is
allocated among the partners (including the partner who receives the GP).
EXAMPLE 10-13 Guaranteed Payment to a Partner

Under a partnership agreement, Meena is to receive 30% of the partnership income, but not less than
$13,000. The partnership has net income of $30,000. Meena’s share, without regard to the minimum
guarantee, is $9,000 (30% × $30,000). The guaranteed payment that can be deducted by the partnership is
$4,000 ($13,000 – $9,000). Meena’s income from the partnership is $13,000, and the remaining $17,000 of
partnership income will be reported by the other partners in proportion to their shares under the partnership
agreement.
If the partnership net income had been $50,000, there would have been no guaranteed payment since
Meena’s share, without regard to the guarantee, would have been greater than the guarantee.
f. For all other purposes, the GP is treated as if made to a partner in his or her capacity as a
partner.
1) A partner is not an employee of the partnership.
EXAMPLE 10-14 Partner’s Ordinary Income

Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without
regard to the income of the partnership. Her distributive share of the partnership income is 10%. The
partnership has $50,000 of ordinary income after deducting the guaranteed payment. She must include
ordinary income of $15,000 [$10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share] on
her individual income tax return for her tax year in which the partnership’s tax year ends.
EXAMPLE 10-15 Partner’s Ordinary Income

Lamont is a calendar-year taxpayer who is a partner in a partnership. The partnership uses a fiscal year
that ended January 31, 2021. Lamont received guaranteed payments from the partnership from February 1,
2020, until December 31, 2020. He must include these guaranteed payments in income for 2021 and report
them on his 2021 income tax return.
Nonpartner Capacity
3. Payments to a partner without regard to income of the partnership for property or for services
not customarily performed by a partner are generally treated as if the transaction took place
between two unrelated persons after arm’s-length negotiations.
a. Loans. Interest paid to a partner on a (true) loan is all gross income to the partner and a
deductible partnership item.
b. Services. Payments to the partner for services rendered (of a nature not normally
performed by a partner) to or for the partnership are gross income to the partner and
generally an ordinary deductible expense of the partnership.
c. Property. A partner acting as a nonpartner (independent third party, outsider) can sell
(or exchange) property to (or with) the partnership and vice versa. Gain or loss on the
transaction is recognized unless an exception applies.
EXAMPLE 10-16 Sale to Partner Acting as a Nonpartner

Partnership sells land to Partner. Partnership recognizes loss unless the sale is to a related party. The loss is
a partnership item allocable to partners as distributive shares. Partner takes a cost basis in the property.
d. Character and loss limit rules.

1) Applicability. These loss limits apply to any transaction between the partnership
and either
a) A partner who owns more than 50% of the partnership or
b) Another partnership if more than 50% of the capital or profits interest of each is
owned by the same persons.
2) Character. Any gain recognized is OI if the property is held as other than a capital
asset by the acquiring partner or partnership.
EXAMPLE 10-17 Sale of Capital Assets -- Change in Character

Dora has held a capital asset for several years. The asset has a basis of $16,000 and a FMV of $24,000.
She sells the asset to a partnership in which she is more than a 50% owner. The partnership will hold the
property as a depreciable asset. Her gain of $8,000 ($24,000 – $16,000) will be ordinary income since she
sold a capital asset to a more-than-50%-owned partnership that is not a capital asset to the partnership. If
the partnership were to hold the asset as a capital asset, her gain would be capital gain.
3) Related party sales.

a) The acquiring party has a cost basis, and a subsequent taxable disposition
event results in no more gain recognition than any excess of realized gain
over the loss previously disallowed.
b) Expenditures are deductible when, and not before, the amount is includible in
gross income by the payee, even if the payor is an accrual-method taxpayer.

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STUDY UNIT TEN

10.1 Partnership Operations and Partner’s Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . 2

A partnership is a business organization other than a corporation, a trust, or an estate, co-owned

10.1 PARTNERSHIP OPERATIONS AND PARTNER’S TAXABLE INCOME

EXAMPLE 10-1 Recourse Liability

EXAMPLE 10-2 Nonrecourse Liabilities

Partnership Cancellation of Debt

Partners’ Capital Accounts

EXAMPLE 10-3 Adjusted Basis of Contributed Property

Partner’s Taxable Income

EXAMPLE 10-4 Postcontribution Gain or Loss

Elections by Partnership or Partner

EXAMPLE 10-5 Year-End Adjusted Basis

EXAMPLE 10-6 Effect of Partnership Liabilities

EXAMPLE 10-7 Effect of Partnership Liabilities

EXAMPLE 10-8 Adjusted Basis of Partner’s Interest

EXAMPLE 10-9 Adjusted Basis of Partner’s Interest

EXAMPLE 10-10 Sale, Exchange, or Other Transfer

EXAMPLE 10-11 Sale, Exchange, or Other Transfer -- Partner Withdrawal

Reporting Requirements of a Partnership

Small Businesses with Gross Receipts $5 Million or Less

10.2 DISTRIBUTION OF PARTNERSHIP ASSETS

EXAMPLE 10-12 Allocation if Available Basis Is Inadequate

10.3 PARTNERS DEALING WITH THEIR OWN PARTNERSHIP

e. For purposes of determining deductibility by the partnership, a GP is treated as if made to

EXAMPLE 10-13 Guaranteed Payment to a Partner

EXAMPLE 10-14 Partner’s Ordinary Income

EXAMPLE 10-15 Partner’s Ordinary Income

EXAMPLE 10-16 Sale to Partner Acting as a Nonpartner

d. Character and loss limit rules.

EXAMPLE 10-17 Sale of Capital Assets -- Change in Character

3) Related party sales.

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