Tax Consequences of a Partnership Transfer for No Consideration

Transferring a partnership interest without receiving payment is often considered a gift. This event has tax implications for the person transferring the interest (the donor), the person receiving it (the donee), and the partnership. A careful examination of the tax rules is required to ensure compliance and understand the financial outcomes for all parties.

Determining if the Transfer is a Gift or a Sale

A transfer of a partnership interest for no apparent payment can be reclassified by the IRS as a part-sale, part-gift transaction. The determining factor is the treatment of partnership liabilities. A partner’s share of the partnership’s debts, including recourse and nonrecourse debt, is included in the calculation of their investment cost, or “outside basis,” in their partnership interest.

When the donor transfers their interest, they are relieved of their share of these liabilities. This relief from debt is treated by tax law as a “deemed cash distribution” to the donor. If this deemed cash payment is greater than the donor’s adjusted outside basis, the transaction is not treated as a pure gift and instead becomes a “disguised sale.”

The calculation is a direct comparison between the liability relief and the donor’s outside basis. For example, imagine a partner has an outside basis of $20,000 and their share of liabilities is $30,000. If they transfer this interest, they are relieved of the $30,000 in liabilities. Because the liability relief exceeds their basis, the partner has a taxable gain of $10,000 from the “sale” portion.

The remaining portion of the transfer is then treated as a gift. The value of the gift is the fair market value of the partnership interest less the amount of the liability relief treated as a sale. This determination dictates the income and gift tax consequences for the donor.

Tax Consequences for the Donor

The donor’s tax impact is determined by the nature of the transfer. This involves potential obligations for both income tax and gift tax.

Income Tax Consequences

If the transfer is classified as a part-sale, the donor must recognize a taxable gain. This gain is calculated as the difference between the amount of liability relief and the portion of the donor’s basis allocated to the sale. The character of this gain, whether it is a capital gain or ordinary income, depends on the nature of the partnership’s underlying assets. In a scenario where the transfer is a pure gift, the donor does not recognize any income tax gain or loss on the transfer.

Gift Tax Consequences

A gift tax analysis is necessary when a partnership interest is transferred for less than its full value. The donor is responsible for reporting this gift to the IRS on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The value of the gift for tax purposes is the fair market value of the transferred interest, reduced by any partnership liabilities the donee assumes.

Federal tax law provides an annual gift tax exclusion, which is $19,000 per recipient for 2025. For any gift value exceeding this annual amount, the donor must file a gift tax return. The excess amount is then applied against the donor’s lifetime gift and estate tax exemption, a unified credit that shields a significant amount of assets from these transfer taxes.

Tax Consequences for the Donee

The tax implications for the donee primarily revolve around establishing their initial outside basis in the partnership interest. This basis figure is used to determine the tax consequences of any future distributions or a subsequent sale of the interest. The rules for calculating this basis depend on whether the transfer was a pure gift or a part-sale, part-gift.

For a transfer characterized as a part-sale, part-gift, the donee’s initial outside basis is the greater of two amounts. It is either the amount the donee is considered to have “paid” for the interest, which is the share of partnership liabilities they assumed, or it is the donor’s basis in the interest at the time of the transfer, known as a “carryover basis.”

When the transfer is a pure gift, the donee’s initial outside basis is the same as the donor’s adjusted basis at the time of the gift. This preserves the tax history of the partnership interest as it moves from donor to donee.

A special “dual-basis” rule applies if the fair market value of the partnership interest is less than the donor’s basis at the time of the gift. In this situation, the donee will have two different basis amounts. For calculating a gain on a future sale, the donee uses the donor’s higher carryover basis. For calculating a loss, the donee must use the lower fair market value at the time of the gift. This rule prevents the transfer of “built-in” losses. The donee’s holding period for the interest generally includes the period the donor held it.

Partnership-Level Considerations and Reporting

Beyond the individual tax consequences, the transfer of a partnership interest necessitates several actions at the partnership level. These steps are important for the partnership’s tax reporting and the donee’s future tax liabilities.

Amending the Partnership Agreement

The partnership agreement must be formally amended. This legal document governs the partnership’s operations and outlines partner responsibilities. The agreement must be updated to officially reflect the removal of the donor and the admission of the donee, ensuring the ownership change is legally recognized.

Section 754 Election

A Section 754 election, made by the partnership, permits an adjustment to the tax basis of its internal assets (the “inside basis”). This adjustment is made specifically for the new partner to align the donee’s share of the inside basis with their outside basis. This can lead to increased depreciation deductions or reduced taxable gain for the donee when the partnership later sells assets. Without this election, the donee may face higher tax liabilities.

Tax Reporting

The partnership must provide a final Schedule K-1 to the donor, reporting their share of partnership items for the tax year up to the transfer date. The partnership will issue an initial Schedule K-1 to the donee, covering the period from the date they acquired the interest. The partnership must also report the transfer on its annual tax return, Form 1065, U.S. Return of Partnership Income.