Partnerships—Conceptual Overview (Portfolio 710)

Tax Management Portfolio, Partnerships — Conceptual Overview, No. 710-2nd, provides a conceptual overview of the federal income tax treatment of partnerships under subchapter K of the Internal Revenue Code.

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Tax Management Portfolio, Partnerships  —  Conceptual Overview, No. 710-2nd, provides a conceptual overview of the federal income tax treatment of partnerships under subchapter K of the Internal Revenue Code. This includes not only an analysis of the relevant statutory and regulatory materials, but also the large body of case law, revenue rulings, and other IRS pronouncements, including technical advice memoranda and private letter rulings, that are all part of this complex body of tax law.

The dual nature of a partnership for tax purposes  —  at times an aggregation of its partners, and at times an entity  —  complicates partnership taxation, particularly because no one, including the author, has been able to articulate a comprehensive statement of when the aggregate aspect and when the entity aspect should predominate. The Portfolio highlights some of the major applications of the aggregate and entity principles in partnership taxation, as an orientation to the principles and structure of Subchapter K, as well as a basis for analyzing partnership problems, for which the authorities provide little meaningful guidance. Partnership taxation is further muddled by the fact that a “tax” partnership includes not only entities organized as general or limited partnerships under state law, but also the newer forms: limited liability partnerships, primarily for professionals, and limited liability companies.

Because most partnership law is a matter of contract among the parties, a major characteristic of the partnership form is its flexibility. Partnership tax principles respect and accommodate that business flexibility, but flexibility can also lead to abuse. Predictably, the Code, the regulations, the IRS, and the courts limit the flexibility. The Portfolio addresses the resulting strains on the application of the aggregate and entity principles, as well as other principles.

The Portfolio examines tax partnerships in detail, distinguishing them from other business relationships. This issue has been simplified by the “check-the-box” regulations that became effective in 1997, and that now allow unincorporated organizations to elect whether to be taxed as partnerships or as associations taxable as corporations. This choice is not available for business entities that are organized as corporations under state law, or for publicly traded partnerships. Special rules apply for foreign entities. Because they remain relevant for controversies involving earlier years, the partnership classification criteria that applied before the check-the-box regulations became effective are summarized. At the other end of the spectrum, partnerships must be distinguished from other relationships that may not constitute business entities, including co-ownership of property, sharing of expenses, and pooling arrangements, as well as employer-employee, debtor-creditor, seller-purchaser, and lessor-lessee relationships. When these other, often informal, arrangements provide for the sharing of profits, they may resemble partnerships. The check-the-box regulations do not apply to these determinations, because they relate to the classification of business entities rather than the determination of whether an arrangement is a business entity. The factors used in determining whether these arrangements are tax partnerships do not necessarily focus on why Subchapter K, or other partnership provisions, should apply. In addition, the election that allows some tax partnerships to be excluded from certain partnership tax provisions is considered.

The Portfolio also provides a general overview of the major federal income tax aspects of conducting business operations through a tax partnership, in the form of a summary statutory outline of the mechanics of partnership taxation, as provided in the Code, regulations, IRS materials, and cases, with an emphasis on the application of aggregate and entity principles. In doing so, it surveys partnership operations according to the following outline: (1) partnership operations generally, and, more specifically, (a) allocating the results of partnership operations among the partners, including according to the special allocation rules, and principles relating to operations financed with nonrecourse liabilities, (b) partnership liabilities, including the allocation of recourse and nonrecourse liabilities, and (c) transactions between partners and partnerships; (2) contributions of property or services by partners, as well as other transactions between partners and partnerships, in properties, and services, including the disguised sale and disguised compensation rules; (3) distributions by partnerships to partners, whether during operations, or in liquidation of the interest of a withdrawing or deceased partner, with an emphasis on the unique nonrecognition provisions; and (4) disposition of partnership interests or partnership businesses, and termination of the partnership.

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Elliott Manning, A.B. (with honors), Columbia College (1955), J.D. magna cum laude, Harvard Law School (1958). Author of Tax Management Portfolio 711 T.M., Partnerships — Formation and Contributions of Property or Services; Choosing the Business Entity (Little Brown 1995); and Corporate Buy-Sell Agreements (Little Brown 1995).


Detailed Analysis

I. Introduction

II. Fundamental Concepts and Principles

Introductory Material

A. Basic Concepts

1. The Aggregate and Entity Principles

a. Overview

(1) Determining and Reporting Partnership Income and Loss

(2) Providing Partnership Capital and Performing Services

(3) Capital Accounts

b. Major Applications of the Aggregate Principle

(1) The Conduit Principle

(2) Transfers Between a Partner and the Partnership

(3) Limiting Conversion

c. Major Applications of the Entity Principle

(1) Tax Accounting

(2) Partnership Interest

(3) Contributions and Distributions of Property

(a) Contributions

(b) New Partners

(c) Distributions

(d) Bifurcation

(e) Disposition of Partnership Interest

(f) Partner Withdrawal

(4) Other Transactions Between a Partner and the Partnership

d. Significance of Distinction Between Aggregate and Entity Theories

2. Partnership Flexibility and Its Limits

a. Major Applications of Partnership Flexibility

(1) Special Allocations

(2) Basis Adjustments Under § § 734 and 743

(3) Redemption of a Partnership Interest

(4) Sale v. Redemption of a Partnership Interest

b. Restrictions on Partnership Flexibility

(1) Disguised Sales

(2) Mixing Bowl Transactions

(3) Family Partnerships

(4) Partnership Taxable Year

(5) Method of Accounting

(6) Retroactive Allocations

(7) Anti-Abuse Rule

(a) Overview

(b) Intent of Subchapter K

(c) Determining the Prohibited Purpose

(d) Principal Purpose

(e) Applying the Intent Rule

(f) Recasting Transactions - Restriction on Entity Treatment

B. Definitions of “Partnership” and “Partner”

1. Corporation v. Partnership

a. Check-the-Box

(1) The Election

(2) Corporations

(3) Disregarded (Single Owner) Entities

(4) Business Entity v. Trust

(5) Publicly Traded Partnerships

(6) Foreign Entities

b. Prior (Kintner) Regulations

(1) Continuity of Life

(2) Centralization of Management

(3) Limited Liability

(4) Free Transferability of Interests

c. LLCs

2. Business Entity - Partnership v. Other Relationships

a. In General

(1) Business Entity

(2) Partnership

b. Conduct of a Business

c. Joint Profit

d. Partnership v. Co-Ownership of Property

(1) Services Provided

(2) Fractional Interests

(3) Development Activities

(4) Other Factors

(5) Co-Ownership from Gift or Bequest

e. Partnership v. Employer-Employee or Principal-Agent

(1) Profit Sharing

(2) Marriage of Capital and Sweat

f. Partnership versus Debtor-Creditor

(1) Bona Fide Debt

(2) Equity Kickers

(3) Debt and Equity Packages

g. Partnership v. Seller-Purchaser

(1) Earnouts

(2) Goodwill

h. Partnership versus Lessor-Lessee

(1) Net Profits

(2) Service Contracts

(3) Licenses

(4) Natural Resources

i. Family Arrangement versus Partnership

j. Partnerships Among or with Controlling Shareholders

(1) Existence of a Partnership

(2) Section 482

(3) Nominee Corporations

(a) Dummy Corporations

(b) Agent Corporation

k. S Corporations

3. Definition of a Partner

a. Ineligible Persons

b. Assignees

c. LLCs

4. Election to Be Excluded from Subchapter K

a. Eligibility for Election

b. Effect of Election

c. Mechanics of Election

III. Taxation of Partnerships and Partners: Statutory Outline

Introductory Material

A. Partnership Operations

1. Determining Partnership Income and Deductions

a. Pass-Through of Income and Losses

b. The Partnership as the Tax Accounting Entity

(1) Method of Accounting

(2) Limits on Cash Method

2. Special Allocations and Capital Accounts

a. Special Allocations - Basic Test

(1) Maintenance of Capital Accounts

(2) Deficit Make-up

(3) Liquidation Rights

(4) Economic Effect Follows Tax Allocation

(5) Substantiality

b. Other Tests

(1) Alternate Test

(2) Economic Effect Equivalence

c. Nonrecourse Deductions

d. Partner's Interest in the Partnership

(1) Liquidation Test

(2) The General Allocation

e. LLC Allocations

f. Summary of Special Allocation Rules

g. Application of Anti-Abuse Rule

h. Family Partnerships

3. Loss Limitations

a. Basis

b. At-Risk Limitation

c. Passive Activity Losses

4. Allocations for Large Partnerships

5. Adjusting the Outside Basis for Partnership Operations

a. Operations and Distributions

b. Partnership Liabilities

(1) Liability

(a) Debt v. Equity

(b) Tax Amount of a Liability

(c) Accounts Payable and Similar Obligations

(d) Recourse and Nonrecourse Liabilities

(2) Sharing Recourse Liabilities

(a) Economic Risk of Loss

(b) Net Payment - Guarantees and Indemnities

(3) Sharing Nonrecourse Liabilities

(a) Partnership Minimum Gain

(b) Section 704(c) Minimum Gain

(c) Profit Shares, But Not Really

(d) Multiple Properties and Liabilities

(4) Exculpatory Liabilities - LLCs

(a) Problems in Applying the Nonrecourse Liability Regulations

(b) Deficits and Discharge of Indebtedness Income

(5) Partner Nonrecourse Debt

(6) The Liability Follows the Loss

6. Timing of Reporting Partnership Profits and Losses

a. Required Tax Years

(1) Business Purpose

(2) New Partnerships

b. Retroactive Allocations

7. Partnership - Partner Transactions

a. Independent Capacity

b. Guaranteed Payments

c. Distinction

8. Continuation of a Partnership

9. Organization and Syndication Fees

10. Partnership Tax Audits

a. TEFRA Audit Procedures

(1) The TMP

(2) Partnership Items

b. Simplified Audit for Large Partnerships

c. Audit Procedures for Small Partnerships

B. Forming a Partnership

1. Contributing Property to a Partnership

a. Nonrecognition of Gain or Loss

b. Basis

(1) Contributing Partner's Outside Basis

(2) Partnership's Inside Basis

(3) Effect of Substituted Basis

(4) Example of Effect of Nonrecognition and Substituted Basis

c. Allocating Income or Deduction Inherent at Contribution - § 704(c)

(1) “Ceiling” Rule

(2) Curative and Remedial Allocations

(3) Reverse § 704(c) Adjustments

d. Holding Period

(1) Tacking and Its Limits

(2) Split Holding Period

e. Nonqualifying Consideration (“Boot”)

f. Liability Transfer

(1) § 1.752-7 Liabilities

(2) “Transfer”

(3) Contribution of Encumbered Property

(a) Effect of Liability Transfer

(b) Nonrecourse and Exculpatory Liabilities

g. Specific Types of Property

(1) Contributing Partner's Debt Obligation

(2) Partnership's Own Indebtedness

(3) Interest in the Partnership - Recapitalization and Noncompensatory Partnership Options

(a) Recapitalization

(b) Noncompensatory Options

(i) Issuance

(ii) Exercise

(iii) Lapse or Repurchase

(iv) Implications

h. Character of Contributed Property - § 724

i. Adding Partners to a Continuing Partnership

(1) Asset Shifts

(2) Liability Shifts

2. Partnership Interest for the Service Provider

a. Intellectual or Intangible Property

b. Partnership Interest for Services

(1) Capital Interest v. Profits Interest

(2) Conditional Promise (Future Capital Interest)

c. Profits Interest for Services

(1) Partnership Profits Interest - Rev. Proc. 93-27

(2) Rev. Proc. 93-27 Exceptions

(3) Disguised Compensation - § 707(a)(2)(A)

(a) Profits Interest for Services to the Partnership

(b) Profits Interest Received in an Independent Capacity

(c) Capitalization

(d) Compensatory Options for, and Restricted Grants of, Partnership Profits Interests

d. Capital Interest for Services

(1) Unrestricted Capital Interest

(2) Restricted Capital Interest

(a) Section 83(a) v. Regs. § 1.721-1(b)(1)

(b) Section 83(b) Election

(c) Status as a Partner

(i) Partnership Losses

(ii) Liability Shares

(3) Partnership Gain Recognition

(4) Options and Other Compensation Based on Partnership Capital Interests

(a) Appreciation Rights and NSOs on Partnership Capital Interests

(b) Controlling Corporate Partner Stock

3. Exceptions to Nonrecognition

a. Sales

b. Disguised Sales

(1) Entrepreneurial Risk

(2) Guaranteed Payments, Preferred Returns, and Cash Flow Distributions

(3) Liabilities

(4) Partnership Interests and Services

c. Rights to Use Property

d. Partnership Investment Companies

e. Foreign Partnerships

4. Initial Expenditures

a. Organizational Expenses

b. Syndication Costs

c. Start-up Expenditures

d. Acquisition Costs of Partnership Assets

(1) In General

(2) The 2004 Regulations

(3) Pre-2004 Law

C. Partnership Distributions

1. Current Distributions

a. Nonrecognition of Gain or Loss

(1) Pro Rata Distributions

(a) Cash Distributions

(b) Property Distributions

(2) Liabilities

(3) Suspended Losses

b. Partner's Basis Consequences

(1) Distributee Partner's Transferred Basis in Distributed Property

(2) Basis Adjustment Without § 754 Election - § 732(d)

(3) Effect on Distributee's Outside Basis

c. Character and Holding Period of Distributed Property

(1) Character of Distributed Property - § 735

(2) Holding Period of Distributed Property

d. Effect on Partnership's Inside Basis - § 754

(1) Partnership's Inside Basis Adjustment Under § 734(b)

(2) Allocating the Inside Basis Adjustment

e. Non-Pro Rata Distributions in Kind - § 751

(1) Determining Gain or Loss

(2) Shares of Partnership Assets

(3) Section 751 Property

f. Mixing Bowl Transactions

(1) Contributed Property Distributed to Another Partner

(2) Other Property Distributed to Contributing Partner

g. Partnership Divisions

(1) Two Forms of Division

(2) Collateral Consequences

h. Disguised Sale by Partnership to Partner

2. Liquidating Distributions

a. Nonrecognition of Gain or Loss

(1) Series of Distributions

(2) Liability Relief

b. Basis of Distributed Property

(1) Allocation of Basis to Distributed Property

(2) Section 737 in Liquidating Distributions

(3) Mandatory Application of § 732(d) in Liquidating Distributions

(4) Anti-Abuse

c. Effect on Partnership's Inside Basis - § 734

3. Withdrawal Payments - § 736

a. Payments for Interest in Partnership - § 736(b)

b. Distributive Share or Guaranteed Payments - § 736(a)

(1) Service Partnerships

(a) Unrealized Receivables

(b) Unspecified Goodwill

(c) Deductible Obligations

(2) Capital Partnerships

(a) Section 736(a) Payments in Capital Partnerships

(b) Deductible Obligations

c. Allocating § 736 Withdrawal Payments

(1) Agreement

(2) Ordinary Losses

(3) Deferred Payments or Distributions

(4) Section 736 Distributions in Kind

D. Disposition of Partnership Interest or Partnership Business; Termination of Partnership

1. Disposition of Partnership Interest

a. Sale v. Withdrawal

b. Sale

(1) Gain or Loss

(a) Allocating Outside Basis on Sale of Part of Partnership Interest

(b) Ordinary Income - § 751(a)

(c) Collectibles and Unrecaptured § 1250 Gain

(d) Deferred Payment Sale

(i) Liabilities

(ii) Disposition

(iii) Seller's Gain for Contingent Payments

(iv) Purchaser's Basis for Contingent Payments

(2) Basis Consequences

(a) Effect on Inside Basis

(b) Adjusting Purchaser's Share of Inside Basis - § 743

(i) Computing the Inside Basis Adjustment

(ii) Effect of the Residual Method

(iii) Tiered Partnerships

c. Disguised Sale of Partnership Interest

d. Abandonment, Forfeiture or Worthlessness

e. Nonrecognition Dispositions

(1) Transferred Basis and Other Attributes

(2) Liabilities

(3) Inside Basis Adjustments

(4) Transfer to Controlled Corporation or in Reorganization

(5) Tiered Partnerships

(a) Transfer to Partnership

(b) Distribution by Partnership

(6) Gratuitous Transfers

(a) Gifts

(b) Charitable Contributions

f. Successor to a Deceased Partner

(1) Section 743(b) Adjustment

(2) Valuing Deceased Partner's Interest

(a) Buy-Sell Agreements

(b) Valuation Discounts and Premiums

(3) Income in Respect of a Decedent

g. Partnership Termination

(1) Sale or Exchange

(2) Contributions, Redemptions, and Gratuitous Transfers

(3) Effect of Termination

h. Partnership Income for Year of Disposition

i. Suspended Losses

(1) Taxable Disposition

(2) Nonrecognition Transfer

2. Disposition of the Partnership Business

a. Sale

(1) Respecting Form

(2) Deferred Payment Sale

(3) Nonrecognition Dispositions

b. Partnership Mergers

c. Incorporating the Going Partnership

(1) Transfer of Partnership Assets (Assets-Over)

(2) Distribution and Contribution of Partnership Assets (Assets-Up)

(3) Transfer of Partnership Interests (Interests-Up)

d. Changing the Legal Form of a Tax Partnership

(1) Change in State Law Form

(2) Partnership to Disregarded Entity

(3) Unincorporated Entity to Corporation


Working Papers

Table of Worksheets

Worksheet 1 Election to be Excluded from Subchapter K (Regs. § 1.761-2(b))

Worksheet 2 Preamble to Final Anti-Abuse Regulations, T.D. 8588 60 Fed. Reg. 23 (1/03/95)

Worksheet 3 Coordinated Issue Paper on Subchapter K Anti-Abuse Rule

Worksheet 4 Preamble to Amendment to Allocation of Partnership Debt Regulations, T.D. 8906, 65 Fed. Reg. 64888 (10/31/00)




Legislative Materials:

Treasury Rulings: