IRC Subchapter K: The Rules of Partnership Taxation

Internal Revenue Code (IRC) Subchapter K contains the federal tax laws governing partnerships and their partners. These rules, found in Sections 701 through 777, provide a framework for businesses where multiple owners contribute assets or labor for a share of profits and losses. Subchapter K implements a “pass-through” system of taxation, meaning the partnership itself does not pay federal income tax. Instead, all financial results, including income, gains, deductions, and losses, flow through to the individual partners who report these items on their personal tax returns. This approach avoids the double taxation that occurs with corporations.

Partnership Formation and Basis

A partnership is formed for tax purposes when two or more parties join to carry on a trade or business, contributing assets like cash or property for an interest in the partnership. Under IRC Section 721, neither the partner nor the partnership recognizes an immediate gain or loss when property is contributed. This rule allows assets to be pooled without an immediate tax liability, applying to contributions at formation or to an existing partnership. For example, if property with a tax basis of $300,000 and a market value of $500,000 is contributed, the $200,000 of appreciation is deferred.

Upon formation, two types of tax basis are established: the “outside basis” and the “inside basis.” The outside basis represents a partner’s tax investment in their partnership interest, while the inside basis is the partnership’s tax basis in the assets it holds. At formation, the total outside basis of all partners usually equals the partnership’s total inside basis.

A partner’s initial outside basis is the amount of cash plus the adjusted basis of any property they contribute. If a partner contributes $50,000 in cash and equipment with an adjusted basis of $20,000, their initial outside basis is $70,000. This figure is used to determine the tax consequences of distributions and the amount of partnership losses a partner can deduct.

Simultaneously, the partnership establishes its inside basis in the contributed assets. Under IRC Section 723, the partnership uses a “carryover basis,” meaning its basis in an asset is the same as the contributing partner’s basis. In the previous example, the partnership’s inside basis in the equipment would be $20,000, which it uses to calculate depreciation and any gain or loss on a future sale.

Allocating Partnership Items

The core of Subchapter K’s operation is how a partnership’s financial results are divided among its partners each year. Allocated items include ordinary business income, capital gains and losses, and charitable contributions, all of which retain their tax character when reported by the partners.

IRC Section 704 states that a partner’s share of these items is determined by the partnership agreement, which allows for flexibility. For instance, a partnership agreement might allocate 70% of profits to one partner and 30% to another, even if their capital contributions were equal.

This flexibility is limited by the requirement that allocations must have “substantial economic effect.” This test ensures that tax allocations align with the partners’ underlying economic arrangement and are not used solely for tax manipulation. If an allocation fails this test, the IRS can reallocate the items according to the partners’ true interest in the partnership.

An allocation has economic effect if it genuinely impacts the dollar amounts the partners will receive. This is achieved by maintaining capital accounts for each partner, which are adjusted for contributions, income, distributions, and losses. Upon liquidation, distributions must follow the positive balances in these capital accounts.

For example, if a two-person partnership with a 50/50 profit-sharing agreement earns $100,000, each partner is allocated $50,000 of income. This allocation increases each partner’s outside basis by that amount, reflecting their increased investment in the partnership.

Partnership Distributions

An allocation of income is a paper entry that adjusts a partner’s basis, while a distribution is an actual transfer of assets from the partnership to a partner. Under IRC Section 731, a partner does not recognize an immediate gain on a distribution. Instead, the distribution is treated as a tax-free return of the partner’s investment, reducing their outside basis.

Gain is recognized only if the amount of cash distributed exceeds the partner’s outside basis immediately before the distribution. For example, if a partner with a $50,000 outside basis receives a $60,000 cash distribution, the first $50,000 is a tax-free return of capital that reduces their basis to zero. The excess $10,000 is treated as a taxable capital gain. For this purpose, distributions of marketable securities are often treated as cash.

Distributions can be either current or liquidating. A current distribution does not terminate a partner’s entire interest, whereas a liquidating distribution does. While the tax treatment for cash is similar in both scenarios, the rules for property distributions and loss recognition can differ. A partner can only recognize a loss on a liquidating distribution and only under specific circumstances.

Transactions Involving Partnership Interests

A partner can transfer their ownership by selling their partnership interest to another person. The tax consequences of such a sale are governed by IRC Section 741, which treats the sale of a partnership interest as the sale of a capital asset. The selling partner calculates gain or loss by subtracting their outside basis from the amount realized from the sale. The amount realized includes cash, the fair market value of property received, and the seller’s share of partnership liabilities assumed by the buyer.

An exception to this capital gain treatment applies to “hot assets” under IRC Section 751. This provision prevents partners from converting ordinary income into lower-taxed capital gains. Hot assets include unrealized receivables and inventory items.

When a partnership holds these assets, a portion of the selling partner’s gain attributable to their share of the hot assets is recharacterized as ordinary income. For instance, if a partner’s total gain is $50,000, but $20,000 of that is from their share of unrealized receivables, they must report $20,000 as ordinary income and the remaining $30,000 as capital gain.

Distinct from the sale of an individual interest, a partnership can terminate for tax purposes. This occurs only if no part of the partnership’s business or financial operation continues to be carried on by any of its partners in a partnership.

Key Basis Adjustments

A partner’s outside basis is not static and is continuously adjusted to reflect partnership activities. One adjustment relates to partnership liabilities, governed by IRC Section 752. This section treats a partner’s share of partnership debt as a component of their investment.

When a partnership’s debt increases or a partner’s share of it increases, it is treated as a cash contribution by that partner, which increases their outside basis. Conversely, a decrease in partnership debt or a partner’s share of it is treated as a cash distribution, which reduces their outside basis. This mechanism ensures a partner’s basis reflects their share of the partnership’s economic risk.

Another basis adjustment is available through a Section 754 election, which a partnership can make to adjust the inside basis of its assets. This is used following the sale of a partnership interest or certain distributions to correct disparities between a new partner’s outside basis and their share of the partnership’s inside basis.

For example, a new partner might buy an interest for a price higher than the selling partner’s share of the inside basis. Without this election, if the partnership later sells an appreciated asset, the new partner would be taxed on a share of the gain that existed before they joined. The election allows for a special basis adjustment under IRC Section 743, ensuring the new partner does not pay tax on the built-in gain they already paid for when buying their interest. The election is binding for future years unless the IRS consents to its revocation.