Partnership Taxation for the CPA Exam
Partnership taxation under IRC Subchapter K (Sections 701-777) is one of the most tested areas on the REG section of the CPA exam. Partnerships are flow-through entities - the partnership itself generally does not pay federal income tax. Instead, income, deductions, gains, losses, and credits flow through to the partners, who report them on their individual returns.
Partnership Formation (IRC §721)
Generally, no gain or loss is recognized when a partner contributes property to a partnership in exchange for a partnership interest. This is the default nonrecognition rule under §721. Exceptions include:
- Services contribution: A partner who contributes services receives a capital interest that is taxable as compensation income at fair market value.
- Disguised sales (§707(a)(2)(B)): If a contribution is really a sale, gain is recognized.
- Liabilities in excess of basis: When a partner contributes property subject to a liability and the partner's share of the partnership's liabilities assumed is less than the liability on the contributed property, the excess is treated as a distribution, potentially triggering gain under §731.
Basis of Contributed Property
The partnership takes a carryover basis in contributed property (§723), and the contributing partner takes an outside basis equal to the adjusted basis of the contributed property plus the partner's share of partnership liabilities (§722). The holding period of the contributed property tacks (§1223(2)).
Partnership Operations
The partnership files an information return (Form 1065) and issues Schedule K-1 to each partner. Items are classified as either:
- Separately stated items: Items that could affect partners differently must be separately stated - capital gains and losses, §1231 gains and losses, charitable contributions, tax-exempt interest, foreign taxes, rental income/losses, and §179 deductions.
- Nonseparately stated income (ordinary business income/loss): All other items of income and deduction are netted to produce ordinary business income or loss.
Guaranteed Payments (§707(c))
Guaranteed payments are payments to a partner for services or use of capital that are determined without regard to partnership income. Key exam points:
- Deductible by the partnership as an ordinary business expense
- Reported as ordinary income by the receiving partner (not self-employment income for capital use payments)
- Subject to self-employment tax when paid for services
- Included in the partner's distributive share for purposes of the partner's tax year
Partner's Outside Basis
Each partner maintains an outside basis in their partnership interest. The basis is adjusted annually:
| Increases | Decreases |
|---|---|
| Contributions of property or cash | Distributions of property or cash |
| Distributive share of income (taxable and tax-exempt) | Distributive share of losses |
| Increase in share of partnership liabilities | Decrease in share of partnership liabilities |
| Nondeductible, noncapital expenditures |
A partner's loss deduction is limited to the partner's outside basis (§704(d)). Losses in excess of basis are suspended and carried forward indefinitely. After the basis limitation, the at-risk rules (§465) and passive activity loss rules (§469) also apply.
Partnership Distributions
Current (Non-Liquidating) Distributions
- Generally no gain recognized unless cash distributed exceeds the partner's outside basis (§731(a)).
- Property received takes a carryover basis from the partnership, limited to the partner's remaining outside basis.
- The partner's outside basis is reduced by cash and the basis of property distributed.
Liquidating Distributions
- No gain unless cash exceeds outside basis; loss is recognized only if the distribution consists solely of cash, unrealized receivables, and inventory.
- Property takes a substituted basis equal to the partner's remaining outside basis (not carryover).
Special Allocations and §704(b)
Partners may agree to allocate items differently from their ownership percentages, but the allocations must have "substantial economic effect" under the §704(b) regulations. The safe harbor requires: (1) capital accounts maintained in accordance with tax regulations, (2) liquidating distributions in accordance with capital account balances, and (3) a deficit restoration obligation or qualified income offset.
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