Partnerships — Formation, Operations & Taxation (2025)

Partnership Basics

• Form 1065 (due March 15, or 3rd month after FYE; extension to Sept 15 via Form 7004)
• Schedule K-1 to each partner by filing deadline (including extension)
• Pass-through taxation — no entity-level tax
• Partners taxed on their DISTRIBUTIVE SHARE, not actual distributions
• General partners: pay SE tax on share. Limited partners: SE tax only on guaranteed payments for services
• Partners working in partnership are NOT employees — no W-2. General partners = self-employed (pay estimated taxes)
• Electronic filing: Required if filing 10+ returns of any type (including info/income/employment/excise returns)

Entities That Cannot Be Partnerships

Corporations, joint-stock companies, insurance companies/banks, government entities, entities required to be taxed as corporations, certain foreign organizations, tax-exempt organizations, REITs, trusts/estates, entities electing corporation status (Form 8832/2553).

Formation — §721

Contributions to partnership generally tax-free. Contributing partner's basis in partnership interest = basis of contributed property + gain recognized (if any) − liabilities assumed by partnership.

Partnership's basis in contributed property = contributing partner's basis (carryover basis). Holding period carries over.

Exceptions to non-recognition:

• Investment company: If partnership would be an investment company if incorporated (>80% assets held for investment as cash/readily marketable items) → gain recognized
• Distribution to different partner within 7 years: Contributing partner recognizes gain (FMV at contribution date vs adjusted basis)
• Disguised sale: Contribution followed by distribution → treated as sale if (1) distribution wouldn't occur without contribution AND (2) distribution right doesn't depend on partnership success

Services for partnership interest:

• Capital interest (right to share in assets upon liquidation): FMV = ordinary income to partner
• Profits interest (share future profits only, no current capital): NOT taxed at receipt (no determinable FMV if partnership would return nothing upon immediate liquidation)

Partner's Outside Basis

Initial basis = cash contributed + adjusted basis of property contributed + services income recognized + share of partnership liabilities.

Adjustments to basis (determined at year-end, unless sale/exchange or full liquidation):

• Increase: additional contributions, partner's share of income (taxable AND tax-exempt), increase in share of partnership debt, excess depreciation over basis
• Decrease: distributions, partner's share of losses, non-deductible expenses (including §179), decrease in share of debt, depletion (up to basis share)

Basis can NEVER go below zero. Losses in excess of basis are suspended and carried forward. If cash distribution or debt reduction exceeds basis → must recognize gain.

Partnership Debt Allocation

• Recourse debt: Allocated to partners who bear economic risk of loss (generally loss-sharing ratios). Partner guaranteed debt = recourse to that partner.
• Nonrecourse debt: Allocated according to profit-sharing ratios (generally). Partner contributing property with nonrecourse debt: debt assumed by partnership reduces contributing partner's basis (other partners' assumption = contribution by them).
• Debt reduction: Treated as distribution to partners (reduces basis)

Capital Accounts

Tax-basis capital accounts track partners' financial interests. Calculated similar to outside basis BUT liabilities do NOT affect capital accounts, and capital accounts CAN go below zero.

Special Allocations

Partnership can allocate income/gains/losses/deductions differently than ownership percentages IF allocations have substantial economic effect per IRS regulations. More flexible than S-corps (which must allocate pro-rata by stock ownership). Example: allocate all depreciation to one partner.

Separately Stated Items

Must be reported separately on K-1 (cannot be netted at partnership level):

• Net short-term and long-term capital gains/losses
• Charitable contributions
• Dividends eligible for DRD
• Foreign taxes paid/accrued
• §1231 gains/losses
• §1250 depreciation recapture
• §179 expense deduction
• Tax-exempt income and related expenses
• Investment income and expenses
• Rental income and expenses
• Recovery items (bad debts, tax refunds)
• Distributions of unrealized receivables/substantially appreciated inventory
• §199A qualified wages and UBIA

Distributions — §731

• Generally tax-free to extent of partner's outside basis
• Cash in excess of outside basis = capital gain
• Property distributions: carryover basis to partner (partnership's adjusted basis)
• Marketable securities treated as cash
• No loss recognized on current (non-liquidating) distributions

"Hot Assets" — §751

Ordinary income recognition required on distributions of:

• Unrealized receivables (unbilled services, depreciation recapture)
• Inventory (substantially appreciated: FMV >120% of basis AND >10% of total assets)

Partner receiving hot asset distribution: if held ≥5 years and becomes capital asset in partner's hands → capital gain treatment.

Sale of Partnership Interest

Generally capital gain/loss. Exceptions:

• Amount attributable to "hot assets" (unrealized receivables, inventory) = ordinary income
• If relieved of partnership debt: debt relief added to amount realized
• Gain/loss = amount realized (including debt relief) − adjusted outside basis

Guaranteed Payments

Fixed payments to partners regardless of partnership income (salary-like). Deductible by partnership, ordinary income to partner. Subject to SE tax (for services). No income tax withholding. §199A: Guaranteed payments EXCLUDED from recipient's QBI (like wages). Also reduces partnership's QBI.

Organizational & Start-Up Costs

• Up to $5,000 organizational costs + $5,000 start-up costs immediately deductible (phased out >$50,000 each)
• Remainder amortized over 180 months (15 years) from month business begins
• Election irrevocable; Form 4562

§707(a) — Non-Partner Transactions

When partner transacts with partnership in non-partner capacity → treated as with third party. OBBBA (2025): Clarified and strengthened — transactions after Jul 4, 2025 where partner acts in non-partner capacity are treated as between partnership and non-partner.

Family Partnerships

• If capital is material income-producing factor: family member must acquire interest through bona fide transaction (gift or purchase), actually own and control interest
• If capital is NOT material factor: family members must genuinely join together in business, each contributing capital or services
• Gifted capital interest: Income allocation limited — must reduce by donor's reasonable compensation for services; gifted share cannot be proportionally larger than donor's capital-attributed share

Qualified Joint Venture (QJV)

• Husband-wife co-owning and operating unincorporated business → normally treated as partnership (Form 1065)
• QJV election: Avoid partnership filing — each spouse files own Schedule C and Schedule SE
• Requirements: MFJ only (cannot be MFS); both spouses materially participate; both are only owners
• If LLC/LLP formed under state law → generally NOT eligible (exception: community property states)
• Community property state spouses holding non-corporate entity as community property can elect QJV

Partnership Termination

Technical termination rules were REPEALED by TCJA (post-2017). Partnership terminates only when:

• All business ceases AND no business/financial operations/risk activities continued by any partner in partnership form
• If terminates before regular year-end → short-year Form 1065 due 15th day of 3rd month after termination date
• Partner's death ends that partner's tax year (final K-1 issued) but does NOT end partnership's tax year

Key Filing Info

Partnership Penalties

• Late filing (Form 1065): $255/month per partner, max 12 months (2025). Partial month counts as full month.
• Late K-1 to partner: $340 per K-1 (2025)
• Both adjusted annually for inflation
• Reasonable cause defense available

Partnership Loss Limitations

1. Outside basis limitation: Cannot deduct losses exceeding partner's outside basis (including share of debt). Suspended losses carry forward until basis restored.
2. At-risk rules (§465): Losses limited to amount at risk — cash contributed, adjusted basis of property contributed, share of recourse liabilities, qualified nonrecourse financing. Most nonrecourse debt NOT included.
3. Passive activity rules (§469): Limited partners generally NOT materially participating (unless specific tests met). General partners subject to material participation tests.