us internal revenue service: p541--1998

8/14/2019 US Internal Revenue Service: p541--1998

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

Important Change for 1998 ............... 2

Important Reminders ......................... 2

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

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

Exclusion From Partnership Rules .. 3

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

Partnership Return (Form 1065) ....... 4

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

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

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

Partnership Distributions .................. 9

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

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

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

Adjusting the Basis of PartnershipProperty ........................................ 17

Form 1065 Example ........................... 17

How To Get More Information .......... 26

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 Regulationssection 301.6231(a)(7)1.

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, the fair market value of other property,and any assumed liability). If a partnershiphas income effectively connected with a tradeor business in the United States, it mustwithhold 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

1998 Returns


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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 Partner's Dis-tributive Share.

Important Reminders

Help with unresolved tax issues. Mostproblems can be solved with one contact by

calling, writing, or visiting an IRS office. Butif you have tried unsuccessfully to resolve aproblem with the IRS, you should contact theTaxpayer Advocate's Problem ResolutionProgram (PRP). Someone at PRP will assignyou a personal advocate who is in the bestposition to try to resolve your problem. TheTaxpayer Advocate can also offer you specialhelp if you have a significant hardship as aresult of a tax problem.

You should contact the Taxpayer Advo-cate if:

You have tried unsuccessfully to resolveyour problem with the IRS and have notbeen contacted by the date promised, or

You are on your second attempt to re-solve a problem.

You may contact a Taxpayer Advocate bycalling a new assistance number, 18777774778. Persons who have access toTTY/TDD equipment can call 18008294059 and ask for the Taxpayer Advocate. Ifyou prefer, you can write to the TaxpayerAdvocate at the office that last contacted you.

While Taxpayer Advocates cannot changethe tax law or make a technical tax decision,they can clear up problems that resulted fromprevious contacts and ensure that your caseis given a complete and impartial review.Taxpayer Advocates are working to put ser-vice first. For more information about PRP,

get Publication 1546, The Problem ResolutionProgram of the Internal Revenue Service.

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 the

IRS, 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's

Share 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 informationabout getting publications and forms.

Forming a PartnershipThe following sections contain general infor-mation about partnerships.

Organizations Classified asPartnershipsAn unincorporated organization with two ormore members is generally classified as apartnership for federal tax purposes if itsmembers carry on a trade, business, financialoperation, or venture and divide its profits.However, a joint undertaking merely to shareexpenses is not a partnership. For example,co-ownership of property maintained andrented or leased is not a partnership unlessthe co-owners provide services to the tenants.

The rules you must use to determinewhether an organization is classified as apartnership changed for organizations formedafter 1996.

Organizations formed after 1996. An or-ganization formed after 1996 is classified asa partnership for federal tax purposes if it hastwo or more members and it is none of thefollowing.

An organization formed under a federalor state law that refers to it as a corpo-ration, body corporate, or body politic.

An organization formed under a state lawthat refers to it as a joint-stock companyor joint-stock association.

An insurance company.

Certain banks.

An organization wholly owned by a stateor local government.

An organization specifically required tobe taxed as a corporation by the InternalRevenue Code (for example, certainpublicly traded partnerships).

Certain foreign organizations.

A tax-exempt organization.

A real estate investment trust.

An organization classified as a trust un-der Regulations section 301.77014 orotherwise subject to special treatmentunder the Internal Revenue Code.

Any other organization that elects to beclassified as a corporation by filing Form8832.

For more information, see the instructions forForm 8832.

Organizations formed before 1997. An or-ganization formed before 1997 and classifiedas a partnership under the old rules will gen-erally continue to be classified as a partner-ship as long as the organization has at leasttwo members and does not elect to be clas-sified as a corporation by filing Form 8832.

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 interest

in 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 haveagreed that contributions of each entitlethem to a share in the profits. Somecapital or service must be provided byeach partner.

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 ordinarily

an income-producing factor if the operationof the business requires substantial invento-ries or investments in plants, machinery, orequipment.

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

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

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The owner withdraws from the partner-ship.

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, the

donee's distributive share of partnership in-come is subject to both of the following re-strictions.

It must be figured by reducing the part-nership income by reasonable compen-sation for services the donor renders tothe partnership.

The donee's distributive share of part-nership income attributable to donatedcapital must not be proportionatelygreater than the donor's distributive shareattributable to the donor's capital.

Purchase. For purposes of determininga partner's distributive share, an interest pur-chased by one family member from another

family member is considered a gift from theseller. The fair market value of the purchasedinterest is considered donated capital. For thispurpose, members of a family include onlyspouses, ancestors, and lineal descendants(or a trust for the primary benefit of thosepersons).

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

Husband-wife partnership. If spouses carryon a business together and share in the pro-fits and losses, they may be partners whetheror not they have a formal partnership agree-ment. If so, they should report income or lossfrom the business on Form 1065. They 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 one of thefollowing events takes place.

1) All its operations are discontinued andno part of any business, financial opera-tion, or venture is continued by any of itspartners in a partnership.

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 section 1.7081(b)(2).

Date of termination. The partnership's taxyear ends on the date of termination. Forpurposes of (1), earlier, the date of termi-nation is the date the partnership completesthe winding up of its affairs. For purposes of(2), earlier, the date of termination is the dateof the sale or exchange of a partnership in-terest that, by itself or together with othersales or exchanges in the preceding 12months, transfers an interest of 50% or morein both capital 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.

Conversion of partnership into limited li-ability company (LLC). The conversion of apartnership into an LLC classified as a part-nership 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.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 Partnership

Liabilities under Basis of Partner's Interest,later.

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

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 purposes.All the partners must agree to make thechoice, and the partners must be able tocompute their own taxable income withoutcomputing the partnership's income. How-ever, the partners are not exempt from therule that limits a partner's distributive shareof partnership loss to the adjusted basis of thepartner's partnership interest. Nor are theyexempt from the requirement of a businesspurpose for adopting a tax year for the part-nership that differs from its required tax year,discussed under Tax Year, later.

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

1) They own the property as co-owners.

2) They reserve the right separately to takeor dispose of their shares of any propertyacquired or retained.

3) They do not actively conduct businessor irrevocably authorize some personacting in a representative capacity topurchase, sell, or exchange the invest-ment property. Each separate participantcan delegate authority to purchase, sell,or exchange his or her share of the in-

vestment property for the time being forhis or her account, but not for a periodof more 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 meetthe following requirements.

1) They own the property as co-owners,either in fee or under lease or other formof contract granting exclusive operatingrights.

2) They reserve the right separately to takein kind or dispose of their shares of any

property produced, extracted, or used.3) They do not jointly sell services or the

property produced or extracted. Eachseparate participant can delegate au-thority to sell his or her share of theproperty produced or extracted for thetime being for his or her account, but notfor a period of time in excess of theminimum needs of the industry, and inno event for more than one year.

However, this exclusion does not apply to anunincorporated organization one of whoseprincipal purposes is cycling, manufacturing,or processing for persons who are not mem-bers of the organization.

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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. This filing date includes any ex-tension of time. See section 1.7612(b) of theRegulations for the procedures to follow.

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 meet

certain 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. For partnership tax years begin-ning after 1997, the death of a partner alsocloses the partnership's tax year for thatpartner. See Distributive Share in Year ofDisposition under Partner's DistributiveShare, later.

Required Tax YearA partnership generally must conform its taxyear to its partners' tax years. The rules fordetermining the required tax year are as fol-lows.

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 partner-ship's majority interest tax year changes,it will not be required to change to an-other tax year for 2 years following theyear of change.

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 the

least 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) Figure the number of months of deferralfor each partner using one partner's taxyear. Count the months from the end ofthat tax year forward to the end of eachother partner's tax year.

2) Multiply each partner's months of defer-ral figured in step (1) by that partner'sinterest in the partnership profits for theyear 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.

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.

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

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

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

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

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

If a partnership changes to the tax yearresulting in the least aggregate deferral of in-come, a statement must be attached to theshort period return showing the computationsused to determine 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 required

tax 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.

Partnership Return(Form 1065)Every partnership that engages in a trade orbusiness or has gross income must file a re-turn on Form 1065 showing its income, de-ductions, and other required information. Inaddition, the partnership return shows thenames and addresses of each partner andeach partner's distributive share of taxableincome. This is an information return andmust be signed by a general partner. If alimited liability company is treated as a part-nership, it must file Form 1065 and one of itsmembers must sign the return.

A partnership is not considered to engagein a trade or business, and is not required tofile a Form 1065, for any tax year in which itneither receives income nor pays or incursany expenses treated as deductions or creditsfor federal income tax purposes.

See the instructions for Form 1065 formore information about who must file Form1065.

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

Months Interest

Year End Year Profits of 12/31: End Interest Deferral Deferral

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

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

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

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

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

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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 filing apartner's personal income tax return or forpaying any tax due on a partner's personalincome tax return.

If the date for filing a return falls on aSaturday, Sunday, or legal holiday, the part-nership can file the return 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 besubject to the rules for consolidated auditproceedings (explained later under Part-ner's Distributive Share, in the dis-cussion Reporting Distributive Share).

CAUTION

!For partnership tax years ending be-fore August 6, 1997, a small partner-

ship met this reasonable cause test ifall of the following applied.

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

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

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

The failure to file penalty is assessedagainst the partnership. However, eachpartner is individually liable for the penalty tothe extent 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.

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 a partner,an employee of the partnership, or an ac-countant. This may also include someonewho signs checks for the partnership or oth-erwise has authority to cause the spendingof partnership funds.

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

Other penalties can be imposed for thefollowing actions.

Not supplying a taxpayer identificationnumber.

Not furnishing information returns.

Overstating tax deposit claims.

Underpaying tax due to a valuation mis-statement.

Not furnishing information on tax shelters.

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 allowedto the partnership.

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

Ordinary income or loss from trade orbusiness activities.

Net income or loss from rental real estateactivities.

Net income or loss from other rental ac-tivities.

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

Gains and losses from sales or ex-changes of property described in section1231 of the Internal Revenue Code.

Charitable contributions.

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

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

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 figure income. Theseinclude choices for the following items.

Accounting method.

Depreciation method.

Method of accounting for specific items,such as depletion or installment sales.

Nonrecognition of gain on involuntaryconversions of property.

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.

Accounting methods: Publication 538.

Depreciation methods: Publication 946.

Installment sales: Publication 537.

Amortization and depletion: Publication535, chapters 12 and 13.

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, the

remaining balance in this account is deduct-ible 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.

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

The amount of each expense.

The date each expense was incurred.

The month the partnership began itsbusiness.

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

A cash basis partnership must also indi-cate the amount paid before the end of theyear for each expense. Expenses less than$10 need not be separately listed, providedthe total amount is listed with the dates onwhich the first and last of the expenses wereincurred.

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 that is a reasonable time before thepartnership begins business and ending withthe date for filing the partnership return (notincluding extensions) for the tax year in whichthe partnership begins business. In addition,the expense must be for creating the part-

nership and not for starting or operating thepartnership trade or business.To satisfy (3), earlier, the expense must

be for a type of item normally expected tobenefit the partnership throughout its entirelife.

Organization expenses that can be amor-tized include the following.

Legal fees for services incident to theorganization of the partnership, such asnegotiation and preparation of a partner-ship agreement.

Accounting fees for services incident tothe organization of the partnership.

Filing fees.

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

Acquiring assets for the partnership ortransferring assets to the partnership.

Admitting or removing partners other thanat the time the partnership is first organ-ized.

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

Syndicating the partnership. Syndication

expenses, such as commissions, profes-sional fees, and printing costs connectedwith the issuing and marketing of inter-ests in the partnership are capitalized.They can never be deducted by thepartnership, even if the syndication isunsuccessful.

Partner's DistributiveShareA partner's taxable income for a tax year in-cludes his or her distributive share of certain

partnership 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 tests are met.

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

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

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 into account allof the following items.

The partner's contributions to the part-nership.

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 distri-butions.

The rights of the partners to distributionsof capital upon liquidation.

Nonrecourse liability. A nonrecourse li-ability is one for which no partner or relatedperson has an economic risk of loss. An al-location of a loss, deduction, or partnershipexpense attributable to nonrecourse liabilitiesnot deductible or chargeable to capital cannothave economic effect. Therefore, a partner'sshare of nonrecourse deductions is deter-mined by his or her interest in the partnership.For the rules on allocating nonrecourse de-ductions, see section 1.7042 of the Regu-lations.

Gross income. When it is necessary to de-

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

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

Generally, the required estimated taxpayment for individuals is the smaller of thefollowing amounts.

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

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. How-

ever, a limited partner generally does not in-clude his or her distributive share of incomeor loss in 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 share

of 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 deduction for his or herdistributive share of a loss may be limited.See Limits on Losses, later.) These items arereported to the partner on Schedule K1(Form 1065).

See the Partner's Instructions for Sched-ule K1 (Form 1065) for more information.The following discussions explain how

partnership items are treated on a partner'sreturn.

Character of items. The character of eachitem of income, gain, loss, deduction, or creditincluded in a partner's distributive share isdetermined as if the partner realized the itemdirectly from the same source as the part-nership or incurred the item in the samemanner as 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.

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Consolidated audit procedures. Undercurrent examination procedures, the taxtreatment of any partnership item is generallydetermined at the partnership level in a con-solidated 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 all partners are one of thefollowing.

An individual (other than a nonresidentalien).

A C corporation.

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) All partners were individuals (other thannonresident aliens) or estates.

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 as

a deduction (up to the partner's basis) at theend of any succeeding year in which thepartner increases his or her basis to morethan zero. See Basis of Partner's Interest,later.

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

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

justed basis of his partnership interest at theend of this year is $1,000.

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

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

A partner is considered at risk for all of thefollowing amounts.

The money and adjusted basis of anyproperty he or she contributed to the ac-tivity.

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

Certain amounts borrowed by the part-nership for use in the activity if the partneris personally liable for repayment or theamounts borrowed are secured by thepartner's property (other than propertyused 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 the

amount 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 income,loss, or credit from passive activities. Be-cause the treatment of each partner's shareof partnership income, loss, or credit dependson the nature of the activity that generated it,the partnership 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 services 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 for Forms 1065 and 8582.

Partner's Exclusions andDeductionsTo determine the allowable amount of anyexclusion or deduction subject to a limit, apartner must combine any separate exclu-sions or deductions on his or her income taxreturn with the distributive share of partner-ship exclusions or deductions before applyingthe limit.

Cancellation of qualified real property

business 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 real

property 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 andthat 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 theRegulations.

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 real

property business debt secured bythat property (as of that time).

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

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

1) Increased by his or her share of thepartnership income from the cancellation

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of 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 shareof debt.

As explained earlier, however, a partner's

election to exclude income from the cancel-lation of qualified real property business debtmay reduce the basis of the partner's interestto the extent the interest is treated as depre-ciable 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 the following rules apply for purposesof determining the ordinary income from re-capture of depreciation under section 1250of the Internal Revenue Code.

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

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.

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 deduction

subject to the limits. It then allocates the de-duction among its partners.Each partner adds the amount allocated

from 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 hisor her allocable share of taxable income de-rived from the partnership's active conduct ofany trade or business.

Basis adjustment. A partner who is al-located section 179 expenses from the part-nership must reduce the basis of his or herpartnership interest by the total section 179expenses allocated, regardless of whether

the full amount allocated can be currentlydeducted. See Adjusted Basis under Basisof Partner's Interest, later. If a partner dis-poses of his or her interest in a partnership,the partner's basis for determining gain orloss is increased by any outstanding carry-over of disallowed deductions of section 179expenses allocated from the partnership.

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

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

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

If an employee of the partnership performspart of a partner's duties and the partnershipagreement requires the partner to pay theemployee out of personal funds, the partner

can 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 thefunds. 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.

Distributive Share in Yearof DispositionIf a partner's entire interest in a partnershipis disposed of, whether by sale, exchange,liquidation, the partner's death, or otherwise,his or her distributive share of partnershipitems must be included in the partner's in-come for the tax year in which membershipin the partnership ends. To compute the dis-tributive share of these items, the partner-

ship's tax year is considered ended on thedate the partner disposed of the interest. Toavoid an interim closing of the partnershipbooks, the partners can agree to estimate thedistributive share by taking the proratedamount the partner would have included inincome if he or she had remained a partnerfor the entire partnership tax year.

CAUTION

!For partnership years beginning be-fore 1998, the partnership's tax yeardid not close for a partner who died.

The decedent's entire share of partnershipitems for the partnership year in which deathoccurred was taxed to the estate or successorin interest, rather than to the decedent on hisor her final return.

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

Example. ABC is a calendar year part-nership with three partners, Alan, Bob, andCathy. Under the partnership agreement,profits and losses are shared in proportion to

each partner's contributions. On January 1the ratio was 90% for Alan, 5% for Bob, and5% for Cathy. On December 1 Bob and Cathyeach contributed additional amounts. Thenew profit and loss sharing ratios were 30%for Alan, 35% for Bob, and 35% for Cathy.For its tax year ended December 31, thepartnership had a loss of $1,200. This lossoccurred equally over the partnership's taxyear. The loss is divided among the partnersas follows:

Certain cash basis items prorated daily.If any partner's interest in a partnershipchanges during the tax year, each partner'sshare of certain cash basis items of the part-nership must be determined by prorating theitems on a daily basis. That daily portion isthen allocated to the partners in proportion totheir interests in the partnership at the closeof each day. This rule applies to the followingitems for which the partnership uses the cashmethod of accounting.

Interest.

Taxes.

Payments for services or for the use ofproperty.

Self-employment income of deceasedpartner. A different rule applies in computinga deceased partner's self-employment in-come for the year of death. The partner'sself-employment income includes the part-ner's distributive share of income earned bythe partnership through the end of the monthin which the partner's death occurs. This istrue even though the deceased partner's es-tate or heirs may succeed to the decedent's

rights in the partnership. For this purpose,partnership income for the year in which apartner dies is considered to be earnedequally in each month.

Example. Larry, a partner in WoodsPar,is a calendar year taxpayer. WoodsPar's fis-cal year ends June 30. For the partnershipyear ending June 30, 1998, Larry's distribu-tive share of partnership profits is $2,000. OnAugust 18, 1998, Larry dies and his estatesucceeds to his partnership interest. For thepartnership year ending June 30, 1999, Larryand his estate's distributive share is $3,000.

Larry's self-employment income to be re-ported on Schedule SE (Form 1040) for 1998is $2,500. This consists of his $2,000 distrib-

Profit Partor Loss of Year Total Share

Partner % Held Loss = of Loss

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

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

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

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utive share for the partnership tax year endingJune 30, 1998, plus $500 (2/12 $3,000) of thedistributive share for the tax year ending June30, 1999.

PartnershipDistributionsPartnership distributions include the following.

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

A distribution of the current year's or prioryears' earnings not needed for workingcapital.

A complete or partial liquidation of apartner's interest.

A distribution to all partners in a completeliquidation 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 or

her 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.

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

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 to the fol-lowing distributions.

A distribution of property to the partnerwho contributed the property to the part-nership.

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

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

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 receiveddoes not exceed the basis of her partnershipinterest, Jo does not recognize any incomeon the distribution. Any gain on the land willbe recognized when she sells or otherwisedisposes of it. The distribution decreases theadjusted basis of Jo's partnership interest to$4,000 [$14,000 ($8,000 + $2,000)].

Marketable securities treated as money.

Generally, a marketable security distributedto a partner is treated as money in determin-ing whether gain is recognized on the distri-bution. This treatment, however, does notgenerally apply if that partner contributed thesecurity to the partnership or an investmentpartnership made the distribution to an eligi-ble 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 market

value immediately before the transactionresulting in the distribution, over

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

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

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

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

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

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

There are exceptions to these generalrules. See the following discussions. Also,see Liquidation at Partner's Retirement or

Deathunder 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 includethe excess 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 7-year period before thedistribution.

CAUTION

!A 5-year period applies to propertycontributed before June 9, 1997, orunder 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 thefollowing amounts.

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.

2) The net precontribution gain of thepartner. This is the net gain the partnerwould recognize if all the property con-tributed by the partner within 7 years (5years for property contributed beforeJune 9, 1997) of the distribution, andheld by the partnership immediately be-fore the distribution, were distributed toanother partner, other than a partnerwho owns more than 50% of the part-nership. See Distribution of contributedproperty to another partnerunder Con-tribution of Property, later.

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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 7years (5 years for property contributed beforeJune 9, 1997) of the distribution to reflect anygain that partner recognizes under this rule.

Exceptions. Any part of a distribution thatis property the partner previously contributedto the partnership is not taken into account indetermining the amount of the excess distri-bution or the partner's net precontributiongain. For this purpose, the partner's previ-ously contributed property does not include acontributed interest in an entity to the extent

its value is due to property contributed to theentity after the interest was contributed to thepartnership.

Recognition of gain under this rule alsodoes not apply to a distribution of unrealizedreceivables or substantially appreciated in-ventory items if the distribution is treated asa sale or exchange, as discussed earlier.

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 receivesa distribution of property that has an adjustedbasis of $20,000 to the partnership and$4,000 in cash. Her basis for the property is$20,000.

Example 2. The adjusted basis of Mike'spartnership interest is $10,000. He receivesa distribution of $4,000 cash and property thathas an adjusted basis to the partnership of

$8,000. His basis for the distributed propertyis limited to $6,000 ($10,000 $4,000, thecash he receives).

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

justed basis of the partner's interest in thepartnership 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, then

the period it was held by that partner is alsoincluded.

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

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

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

signed bases by the amount of the ex-cess. If the total of these assigned basesexceeds the allocable basis, decreasethe assigned bases by the amount of theexcess.

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

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

To figure her basis in each property, Juliefirst assigns bases of $5,000 to property Aand $10,000 to property B (their adjustedbases to the partnership). This leaves a$40,000 basis increase (the $55,000allocable basis minus the $15,000 total of theassigned bases). She first allocates $35,000

to 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. Use thefollowing rules to allocate any basis decreaserequired in rule (1) or rule (2), earlier.

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 receives

properties C and D, neither of which is in-ventory or unrealized receivables. PropertyC has an adjusted basis to the partnershipof $15,000 and a fair market value of $15,000.Property D has an adjusted basis to thepartnership of $15,000 and a fair marketvalue of $5,000.

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

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

1) Allocate the basis first to unrealizedreceivables and inventory items includedin the distribution to the extent of thepartnership's adjusted basis in thoseitems. If the partnership's adjusted basisin those items exceeded 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 to

their adjusted bases to the partnership.

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 allowed

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or 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 bemade for the distribution year, it must bemade with the return for the first year in whichthe basis of the distributed property is perti-nent in determining the partner's income tax.

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

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

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

special adjustment to basis mustbe made fora distribution of property, whether or not thedistribution is made within 2 years after thepartnership interest was acquired, if all of thefollowing conditions existed when the partnerreceived the partnership interest.

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

2) If there had been a liquidation of thepartner's interest immediately after it wasacquired, an allocation of the basis ofthat interest under the general rules(discussed earlier under Basis divided

among properties) would have de-creased the basis of property that couldnot be depreciated, depleted, or amor-tized and increased the basis of propertythat could be.

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

Marketable securities. A partner's basis inmarketable securities received in a partner-

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

Transactions BetweenPartnership 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 the fol-lowing.

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 to

a partnership ifa) There is a related transfer of money

or 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. The

partnership 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 deductedby 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 1998, a partner who qualifies can de-duct 45% 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.

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 income

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after 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, 1998. Mike received guaranteedpayments from the partnership from February1, 1997, until December 31, 1997. He must

include these guaranteed payments in in-come for 1998 and report them on his 1998income tax return.

Payments resulting in loss. If guaran-teed payments to a partner result in a part-nership loss in which the partner shares, thepartner must report the full amount of theguaranteed payments as ordinary income.The partner separately takes into account hisor her distributive share of the partnershiploss, to the extent of the adjusted basis of thepartner's partnership interest.

Sale or Exchangeof Property

Special rules apply to a sale or exchange ofproperty between a partnership and certainpersons.

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

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

The basis of each partner's interest in thepartnership is decreased (but not below zero)

by the partner's share of the disallowed loss.If the purchaser later sells the property,o

us internal revenue service: p541--1998

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