assignment of income to partnership

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

Marcum Announces Acquisition Agreement to Join CBIZ Learn More

• Newsletters
• Client Portal
• Make Payment
• (855) Marcum1

Search our Services and Industries

Tax issues to consider when a partnership interest is transferred.

By Colleen McHugh - Co‑Partner‑in‑Charge, Alternative Investments

There can be several tax consequences as a result of a transfer of a partnership interest during the year. This article discusses some of those tax issues applicable to the partnership.

Adjustments to the Basis of Partnership Property Upon a transfer of a partnership interest, the partnership may elect to, or be required to, increase/decrease the basis of its assets. The basis adjustments will be for the benefit/detriment of the transferee partner only.

• If the partnership has a special election in place, known as an IRS Section 754 election, or will make one in the year of the transfer, the partnership will adjust the basis of its assets as a result of the transfer. IRS Section 754 allows a partnership to make an election to “step-up” the basis of the assets within a partnership when one of two events occurs: distribution of partnership property or transfer of an interest by a partner.
• The partnership will be required to adjust the basis of its assets when an interest in the partnership is transferred if the total adjusted basis of the partnership’s assets is greater than the total fair market value of the partnership’s assets by more than $250,000 at the time of the transfer.

Ordinary Income Recognized by the Transferor on the Sale of a Partnership Interest Typically, when a partnership interest is sold, the transferor (seller) will recognize capital gain/loss. However, a portion of the gain/loss could be treated as ordinary income to the extent the transferor partner exchanges all or a part of his interest in the partnership attributable to unrealized receivables or inventory items. (This is known as “Section 751(a) Property” or “hot” assets).

• Unrealized receivables – includes, to the extent not previously included in income, any rights (contractual or otherwise) to payment for (i) goods delivered, or to be delivered, to the extent the proceeds would be treated as amounts received from the sale or exchange of property other than a capital asset, or (ii) services rendered, or to be rendered.
• Property held primarily for sale to customers in the ordinary course of a trade or business.
• Any other property of the partnership which would be considered property other than a capital asset and other than property used in a trade or business.
• Any other property held by the partnership which, if held by the selling partner, would be considered of the type described above.

Example – Partner A sells his partnership interest to D and recognizes gain of $500,000 on the sale. The partnership holds some inventory property. If the partnership sold this inventory, Partner A would be allocated $100,000 of that gain. As a result, Partner A will recognize $100,000 of ordinary income and $400,000 of capital gain.

The partnership needs to provide the transferor with sufficient information in order to determine the amount of ordinary income/loss on the sale, if any.

Termination/Technical Termination of the Partnership A transfer of a partnership interest could result in an actual or technical termination of the partnership.

• The partnership will terminate on the date of transfer if there is one tax owner left after the transfer.
• The partnership will have a technical termination for tax purposes if within a 12-month period there is a sale or exchange of 50% or more of the total interest in the partnership’s capital and profits.

Example – D transfers its 55% interest to E. The transfer will result in the partnership having a technical termination because 50% or more of the total interest in the partnership was transferred. The partnership will terminate on the date of transfer and a “new” partnership will begin on the day after the transfer.

Allocation of Partnership Income to Transferor/Transferee Partners When a partnership interest is transferred during the year, there are two methods available to allocate the partnership income to the transferor/transferee partners: the interim closing method and the proration method.

• Interim closing method – Under this method, the partnership closes its books with respect to the transferor partner. Generally, the partnership calculates the taxable income from the beginning of the year to the date of transfer and determines the transferor’s share of that income. Similarly, the partnership calculates the taxable income from the date after the transfer to the end of the taxable year and determines the transferee’s share of that income. (Note that certain items must be prorated.)

Example – Partner A transfers his 10% interest to H on June 30. The partnership’s taxable income for the year is $150,000. Under the interim closing method, the partnership calculates the taxable income from 1/1 – 6/30 to be $100,000 and from 7/1-12/31 to be $50,000. Partner A will be allocated $10,000 [$100,000*10%] and Partner H will be allocated $5,000 [$50,000*10%].

• Proration method – this method is allowed if agreed to by the partners (typically discussed in the partnership agreement). Under this method, the partnership allocates to the transferor his prorata share of the amount of partnership items that would be included in his taxable income had he been a partner for the entire year. The proration may be based on the portion of the taxable year that has elapsed prior to the transfer or may be determined under any other reasonable method.

Example – Partner A transfers his 10% interest to H on June 30. The partnership’s taxable income for the year is $150,000. Under the proration method, the income is treated as earned $74,384 from 1/1 – 6/30 [181 days/365 days*$150,000] and $75,616 from 7/1-12/31 [184 days/365 days*$150,000]. Partner A will be allocated $7,438 [$74,384*10%] and Partner H will be allocated $7,562 [$75,616*10%]. Note that this is one way to allocate the income. The partnership may use any reasonable method.

Change in Tax Year of the Partnership The transfer could result in a mandatory change in the partnership’s tax year. A partnership’s tax year is determined by reference to its partners. A partnership may not have a taxable year other than:

• The majority interest taxable year – this is the taxable year which, on each testing day, constituted the taxable year of one or more partners having an aggregate interest in partnership profits and capital of more than 50%.

Example – Partner A, an individual, transfers his 55% partnership interest to Corporation D, a C corporation with a year-end of June 30. Prior to the transfer, the partnership had a calendar year-end. As a result of the transfer, the partnership will be required to change its tax year to June 30 because Corporation D now owns the majority interest.

• If there is no majority interest taxable year or principal partners, (a partner having a 5% or more in the partnership profits or capital) then the partnership adopts the year which results in the least aggregate deferral.

Change in Partnership’s Accounting Method A transfer of a partnership interest may require the partnership to change its method of accounting. Generally, a partnership may not use the cash method of accounting if it has a C corporation as a partner. Therefore, a transfer of a partnership interest to a C corporation could result in the partnership being required to change from the cash method to the accrual method.

As described in this article, a transfer of a partnership interest involves an analysis of several tax consequences. An analysis should always be done to ensure that any tax issues are dealt with timely.

If you or your business are involved in a transfer described above, please contact your Marcum Tax Professional for guidance on tax treatment.

Related Insights & News

Treasury and IRS Unveil Proposed Dual Consolidated Loss Regulations Impacting Global Tax Compliance

The Department of the Treasury and the IRS unveiled proposed regulations addressing the dual consolidated loss rules and their interplay with the OCED's Pillar Two global tax regime.

Presidential Election 2024: What Trump vs. Harris Could Mean for Federal Business Taxes

Clearing the fog: anticipating the impact of the 2025 tax cliff, maximize savings and sustainability: exploring the ira’s comprehensive energy incentives, employee retention tax credit (ertc) claims under scrutiny: key irs developments explained, upcoming events.

Marcum Manufacturing Forum

Cleveland, OH

Cocktails & Conversations

Economic Update and Forecast

Enhancing Bank Operations with Specialized Managed IT Services

Cocktails & Construction

New York, NY

Building Hope: Mental Health and Suicide Prevention in the Construction Industry

Rethink Financial Forecasting: Turning Traditional Budgeting and Forecasting on Its Head

Legislative Updates to Governmental Contracting

Federal Single Audit Updates

Rooftop Cyber Mixer

Advancing Your Investigations with Geospatial Data

Elevating Network Security and Efficiency: The Future with SASE

The Business of Cannabis: A Legal and Accounting Update

Freeport, ME

FASB Updates and Uniform Guidance Changes for Nonprofits

Marcum Women’s Initiative: Words on Wood

Wallingford, CT

Empowering Credit Unions through Specialized Managed IT Services

OPEBs: To Fund or Not to Fund?

Tech Mixer: Rooftop Networking with IT Leaders

Providence, RI

Marcum Mid-South Construction Summit

Nashville, TN

Staying Proactive Not Reactive: Proposed Changes to the R&D Tax Credit Form 6765

Today’s Cybersecurity Landscape

Bedford, NH

Transfer Pricing Tricks and Treats: Unmasking Insights in Q4

GASB Update

Marcum Women’s Initiative: Floral Arrangement Class

South Portland, ME

Economic & Market Update

Marcum Ohio Construction Summit

Warrensville Heights, OH

Melville, NY

Marcum Tech Top 40

ERP Spook Tales: Confronting the Monsters of Changing Systems

Client Kickoff: Hawkeye Tailgate & Game Day 

Iowa City, IA

FSMA Fundamentals: Proactive Food Safety for Your Business

Dental Transition Services Social

Ballwin, MO

Leading Gen Z: Optimizing Teamwork and Performance in the Construction Industry

Tech Huddle: Networking Mixer for IT Leaders

Maximizing Direct Pay Opportunities for Your Nonprofit

Foundations of Estate Planning – Wills, Trusts and other Essentials

Related service.

Tax & Business

Have a Question? Ask Marcum

What is “Assignment of Income” Under the Tax Law?

Gross income is taxed to the individual who earns it or to owner of property that generates the income. Under the so-called “assignment of income doctrine,” a taxpayer may not avoid tax by assigning the right to income to another.

Specifically, the assignment of income doctrine holds that a taxpayer who earns income from services that the taxpayer performs or property that the taxpayer owns generally cannot avoid liability for tax on that income by assigning it to another person or entity. The doctrine is frequently applied to assignments to creditors, controlled entities, family trusts and charities.

A taxpayer cannot, for tax purposes, assign income that has already accrued from property the taxpayer owns. This aspect of the assignment of income doctrine is often applied to interest, dividends, rents, royalties, and trust income. And, under the same rationale, an assignment of an interest in a lottery ticket is effective only if it occurs before the ticket is ascertained to be a winning ticket.

However, a taxpayer can shift liability for capital gains on property not yet sold by making a bona fide gift of the underlying property. In that case, the donee of a gift of securities takes the “carryover” basis of the donor.  

For example, shares now valued at $50 gifted to a donee in which the donor has a tax basis of $10, would yield a taxable gain to the donee of its eventual sale price less the $10 carryover basis. The donor escapes income tax on any of the appreciation.

For guidance on this issue, please contact our professionals at 315.242.1120 or [email protected] .

Share This Story, Choose Your Platform!

Privacy overview.

Necessary cookies are absolutely essential for the website to function properly. This category only includes cookies that ensures basic functionalities and security features of the website. These cookies do not store any personal information.

Any cookies that may not be particularly necessary for the website to function and is used specifically to collect user personal data via analytics, ads, other embedded contents are termed as non-necessary cookies. It is mandatory to procure user consent prior to running these cookies on your website.

An official website of the United States Government

• Kreyòl ayisyen
• Search Toggle search Search Include Historical Content - Any - No Include Historical Content - Any - No Search
• Menu Toggle menu
• INFORMATION FOR…
• Individuals
• Business & Self Employed
• Charities and Nonprofits
• International Taxpayers
• Federal State and Local Governments
• Indian Tribal Governments
• Tax Exempt Bonds
• FILING FOR INDIVIDUALS
• How to File
• When to File
• Where to File
• Update Your Information
• Get Your Tax Record
• Apply for an Employer ID Number (EIN)
• Check Your Amended Return Status
• Get an Identity Protection PIN (IP PIN)
• File Your Taxes for Free
• Bank Account (Direct Pay)
• Payment Plan (Installment Agreement)
• Electronic Federal Tax Payment System (EFTPS)
• Your Online Account
• Tax Withholding Estimator
• Estimated Taxes
• Where's My Refund
• Direct Deposit
• Reduced Refunds
• Amend Return

Credits & Deductions

• INFORMATION FOR...
• Businesses & Self-Employed
• Earned Income Credit (EITC)
• Child Tax Credit
• Clean Energy and Vehicle Credits
• Standard Deduction
• Retirement Plans

Forms & Instructions

• POPULAR FORMS & INSTRUCTIONS
• Form 1040 Instructions
• Form 4506-T
• POPULAR FOR TAX PROS
• Form 1040-X
• Circular 230

Withholding on foreign partner or firm.

Fixed or determinable annual or periodical (FDAP) income.

Withholding under the Foreign Investment in Real Property Tax Act (FIRPTA).

Withholding on foreign partner’s effectively connected taxable income (ECTI).

Withholding on foreign partner’s sale of a partnership interest.

Withholding under the Foreign Account Tax Compliance Act (FATCA).

Comments and suggestions.

Getting answers to your tax questions.

Getting tax forms, instructions, and publications.

Ordering tax forms, instructions, and publications.

• Useful Items - You may want to see:

Organizations formed after 1996.

Limited liability company (LLC).

Organizations formed before 1997.

Community property.

Gift of capital interest.

Purchase considered gift.

Applicable partnership interest (API).

Applicable trade or business.

Specified assets.

Business Owned and Operated by Spouses

Qualified joint venture election, partnership agreement.

Date of termination.

Short period return.

Conversion of partnership into LLC.

Electronic Filing

Investing partnership.

Operating agreement partnership.

Electing the exclusion.

Partnership Return (Form 1065)

Effect on partner's basis.

Effect on partnership.

Certain distributions treated as a sale or exchange.

Substantially appreciated inventory items.

Qualified opportunity investment.

Marketable securities treated as money.

Loss on distribution.

Distribution of partner's debt.

Net precontribution gain.

Effect on basis.

Exceptions.

Complete liquidation of partner's interest.

Partner's holding period.

Basis divided among properties.

Allocating a basis increase.

Allocating a basis decrease.

Distributions before August 6, 1997.

Partner's interest more than partnership basis.

Special adjustment to basis.

Mandatory adjustment.

Required statement.

Marketable securities.

Payments by accrual basis partnership to cash basis partner.

Minimum payment.

Self-employed health insurance premiums.

Including payments in partner's income.

Payments resulting in loss.

More than 50% ownership.

More information.

Disguised sales.

Form 8275 required.

Contribution to partnership treated as investment company.

Contribution to foreign partnership.

Basis of contributed property.

Allocations to account for built-in gain or loss.

Distribution of contributed property to another partner.

Disposition of certain contributed property.

Capital interest.

Profits interest.

Interest acquired by gift, etc.

Partner's liabilities assumed by partnership.

Book value of partner's interest.

When determined.

Alternative rule for figuring adjusted basis.

Partner's basis increased.

Partner's basis decreased.

Assumption of liability.

Related person.

Property subject to a liability.

Partner's share of recourse liabilities.

Constructive liquidation.

Limited partner.

Partner's share of nonrecourse liabilities.

Abandoned or worthless partnership interest.

Partnership election to adjust basis of partnership property.

Installment reporting for sale of partnership interest.

Unrealized receivables.

Other items treated as unrealized receivables.

Determining gain or loss.

Inventory items.

Notification required of partner.

Information return required of partnership.

Statement required of partner.

Partner's disposition of distributed unrealized receivables or inventory items.

Exception for inventory items held more than 5 years.

Substituted basis property.

Foreign partner's transfer of an interest in a partnership engaged in the conduct of a U.S. trade or business.

Liquidating payments.

Unrealized receivables and goodwill.

Partners' valuation.

Gain or loss on distribution.

Other payments.

Calculation and reporting for the API 1-year distributive share amount and 3-year distributive share amount by a pass-through entity

Calculation and reporting of recharacterization amount by the owner taxpayer, the owner taxpayer reporting of the recharacterization amount on schedule d (form 1040) or schedule d (form 1041) and on form 8949.

Reporting example for Worksheets A and B.

Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)

Role of partnership representative, electing out of the centralized partnership audit regime.

AARs filed under the centralized partnership audit regime.

Partner amended return filed as part of modification of the imputed underpayment during a BBA examination.

How To Sign Documents on Behalf of the Partnership

Preparing and filing your tax return.

Free options for tax preparation.

Using online tools to help prepare your return.

Need someone to prepare your tax return?

Advance child tax credit payments.

Coronavirus.

Employers can register to use Business Services Online.

IRS social media.

Watching IRS videos.

Online tax information in other languages.

Free Over-the-Phone Interpreter (OPI) Service.

Accessibility Helpline available for taxpayers with disabilities.

Getting tax forms and publications.

Getting tax publications and instructions in eBook format.

Access your online account (individual taxpayers only).

Tax Pro Account.

Using direct deposit.

Getting a transcript of your return.

Reporting and resolving your tax-related identity theft issues.

Ways to check on the status of your refund.

Making a tax payment.

What if I can’t pay now?

Filing an amended return.

Checking the status of your amended return.

Understanding an IRS notice or letter you’ve received.

Contacting your local IRS office.

What Is TAS?

How can you learn about your taxpayer rights, what can tas do for you, how can you reach tas, how else does tas help taxpayers, tas for tax professionals, low income taxpayer clinics (litcs), section 1061 worksheets and tables, publication 541 - additional material, publication 541 (03/2022), partnerships.

Revised: March 2022

Publication 541 - Introductory Material

Section 1061 reporting. Section 1061 recharacterizes certain long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains. An applicable partnership interest is an interest in a partnership that is transferred to or held by a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer or any other related person, in an applicable trade or business. See Section 1061 Reporting Instructions for more information.

Schedules K-2 and K-3 (Form 1065). New Schedules K-2 and K-3 replace the reporting of certain international transactions on Schedules K and K-1. The new schedules are designed to provide greater clarity for partners on how to compute their U.S. income tax liability with respect to items of international tax relevance, including claiming deductions and credits. See the Instructions for Schedules K-2 and K-3 for more information.

Photographs of missing children. The Internal Revenue Service is a proud partner with the National Center for Missing & Exploited Children® (NCMEC) . Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.

Introduction

This publication provides supplemental federal income tax information for partnerships and partners. It supplements the information provided in the Instructions for Form 1065, U. S. Return of Partnership Income; the Partner's Instructions for Schedule K-1 (Form 1065); and Instructions for Schedule K-2 and Schedule K-3 (Form 1065). Generally, a partnership doesn't pay tax on its income but “passes through” any profits or losses to its partners. Partners must include partnership items on their tax returns.

For a discussion of business expenses a partnership can deduct, see Pub. 535, Business Expenses. Members of oil and gas partnerships should read about the deduction for depletion in chapter 9 of that publication.

For tax years beginning before 2018, certain partnerships must have a tax matters partner (TMP) who is also a general partner.

The TMP has been replaced with partnership representative for partnership tax years beginning after 2017. Each partnership must designate a partnership representative unless the partnership has made a valid election out of the centralized partnership audit regime. See Designated partnership representative in the Form 1065 instructions and Regulations section 301.6223-1.

A partnership that has foreign partners or engages in certain transactions with foreign persons may have one (or more) of the following obligations.

A partnership may have to withhold tax on distributions to a foreign partner or a foreign partner’s distributive share when it earns income not effectively connected with a U.S. trade or business. A partnership may also have to withhold on payments to a foreign person of FDAP income not effectively connected with a U.S. trade or business. See section 1441 or 1442 for more information.

If a partnership acquires a U.S. real property interest from a foreign person or firm, the partnership may have to withhold tax on the amount it pays for the property (including cash, the fair market value (FMV) of other property, and any assumed liability). See section 1445 for more information.

If a partnership has income effectively connected with a trade or business in the United States (including gain on the disposition of a U.S. real property interest), it must withhold on the ECTI allocable to its foreign partners. See section 1446(a) for more information.

A purchaser of a partnership interest, which may include the partnership itself, may have to withhold tax on the amount realized by a foreign partner on the sale for that partnership interest if the partnership is engaged in a trade or business in the United States. See section 1446(f) for more information.

A partnership may have to withhold tax on distributions to a foreign partner of a foreign partner’s distributive share when it earns withholdable payments. A partnership may also have to withhold on withholdable payments that it makes to a foreign entity. See sections 1471 through 1474 for more information. A partnership that has a duty to withhold but fails to withhold may be held liable for the tax, applicable penalties, and interest. See section 1461 for more information.

For more information on withholding on nonresident aliens and foreign entities, see Pub. 515.

We welcome your comments about this publication and suggestions for future editions.

You can send us comments through IRS.gov/FormComments . Or, you can write to the Internal Revenue Service, Tax Forms and Publications, 1111 Constitution Ave. NW, IR-6526, Washington, DC 20224.

Although we can’t respond individually to each comment received, we do appreciate your feedback and will consider your comments and suggestions as we revise our tax forms, instructions, and publications. Don’t send tax questions, tax returns, or payments to the above address.

If you have a tax question not answered by this publication or the How To Get Tax Help section at the end of this publication, go to the IRS Interactive Tax Assistant page at IRS.gov/Help/ITA where you can find topics by using the search feature or viewing the categories listed.

Go to IRS.gov/Forms to download current and prior-year forms, instructions, and publications.

Go to IRS.gov/OrderForms to order current forms, instructions, and publications; call 800-829-3676 to order prior-year forms and instructions. The IRS will process your order for forms and publications as soon as possible. Don’t resubmit requests you’ve already sent us. You can get forms and publications faster online.

Useful Items

Publication

334 Tax Guide for Small Business

505 Tax Withholding and Estimated Tax

515 Withholding of Tax on Nonresident Aliens and Foreign Entities

535 Business Expenses

537 Installment Sales

538 Accounting Periods and Methods

544 Sales and Other Dispositions of Assets

551 Basis of Assets

925 Passive Activity and At-Risk Rules

946 How To Depreciate Property

See How To Get Tax Help at the end of this publication for information about getting publications and forms.

Publication 541 - Main Contents

Forming a partnership.

The following sections contain general information about partnerships.

Organizations Classified as Partnerships

An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. However, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.

The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed after 1996.

An organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members and it is none of the following.

An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic.

An organization formed under a state law that refers to it as a joint-stock company or joint-stock association.

An insurance company.

Certain banks.

An organization wholly owned by a state, local, or foreign government.

An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships).

Certain foreign organizations identified in Regulations section 301.7701-2(b)(8).

A tax-exempt organization.

A real estate investment trust (REIT).

An organization classified as a trust under Regulations section 301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code.

Any other organization that elects to be classified as a corporation by filing Form 8832.

An LLC is an entity formed under state law by filing articles of organization as an LLC. Unlike a partnership, none of the members of an LLC are personally liable for its debts. However, if the LLC is an employer, an LLC member may be liable for employer-related penalties. See Pub. 15, Employer’s Tax Guide (Circular E), and Pub. 3402, Taxation of Limited Liability Companies. An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in Regulations section 301.7701-3. See Form 8832 and Regulations section 301.7701-3 for more details.

An organization formed before 1997 and classified as a partnership under the old rules will generally continue to be classified as a partnership as long as the organization has at least two members and doesn't elect to be classified as a corporation by filing Form 8832.

Spouses who own a qualified entity (defined below) can choose to classify the entity as a partnership for federal tax purposes by filing the appropriate partnership tax returns. They can choose to classify the entity as a sole proprietorship by filing a Schedule C (Form 1040) listing one spouse as the sole proprietor. A change in reporting position will be treated for federal tax purposes as a conversion of the entity.

A qualified entity is a business entity that meets all the following requirements.

The business entity is wholly owned by spouses as community property under the laws of a state, a foreign country, or a possession of the United States.

No person other than one or both spouses would be considered an owner for federal tax purposes.

The business entity is not treated as a corporation.

For more information about community property, see Pub. 555, Community Property. Pub. 555 discusses the community property laws of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

Partnership Interests Created by Gift

If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is a material income-producing factor, the donee's distributive share of partnership income is subject to both of the following restrictions.

It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the partnership.

The donee's distributive share of partnership income attributable to donated capital must not be proportionately greater than the donor's distributive share attributable to the donor's capital.

For purposes of determining a partner's distributive share, an interest purchased by one family member from another family member is considered a gift from the seller. The FMV of the purchased interest is considered donated capital. For this purpose, members of a family include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons).

Partnership Interests Held in Connection With Performance of Services

Section 1061 recharacterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains. The provision generally requires that a capital asset be held for more than 3 years for capital gain and loss allocated with respect to any applicable partnership interest (API) to be treated as long-term capital gain or loss. Proposed Regulations ( REG-107213-18 ) were published in the Federal Register on August 14, 2020. Final regulations (Treasury Decision (T.D.) 9945) were published in the Federal Register on January 19, 2021. T.D. 9945, 2021-5 I.R.B. 627, is available at IRS.gov/irb/2021-5_IRB#TD-9945 . Owner taxpayers and pass-through entities may rely on the proposed regulations for tax years beginning before January 19, 2021, (the date final regulations were published in the Federal Register) provided they follow the proposed regulations in their entirety and in a consistent manner. An owner taxpayer or pass-through entity may choose to apply the final regulations to a tax year beginning after December 31, 2017, provided that they consistently apply the final section 1061 regulations in their entirety to that year and all subsequent years. Owner taxpayers and pass-through entities must apply the final regulations to tax years beginning on or after January 19, 2021. See Section 1061 Reporting Instructions , later.

An API is any interest in a partnership that, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any “applicable trade or business.” The special recharacterization rule applies to:

Capital gains recognized by a partner from the sale or exchange of an applicable partnership interest under sections 741(a) and 731(a); and

Capital gains recognized by a partnership, allocated to a partner with respect to an API.

An applicable trade or business means any activity conducted on a regular, continuous, and substantial basis (regardless of whether the activity is conducted through one or more entities) which consists in whole or in part of raising and returning capital, and either :

Investing in or disposing of “specific assets” (or identifying specified assets for investing or disposition), or

Developing specified assets.

Specified assets are:

Securities (as defined in section 475(c)(2), under rules for mark-to-market accounting for securities dealers);

Commodities (as defined under rules for mark-to-market accounting for commodities dealers in section 475(e)(2));

Real estate held for rental or investment;

Options or derivative contracts with respect to such securities;

Cash or cash equivalents; or

An interest in a partnership to the extent of the partnership’s proportionate interest in the foregoing.

A security for this purpose means any of the following.

Share of corporate stock.

Partnership interest or beneficial ownership interest in a widely held or publicly traded partnership or trust.

Note, bond, debenture, or other evidence of indebtedness.

Interest rate, currency, or equity notional principal contract.

Interest in, or derivative financial instrument in, any such security or any currency (regardless of whether section 1256 applies to the contract).

Position that is not such a security and is a hedge with respect to such a security and is clearly identified.

If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065. They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor. However, the spouses can elect not to treat the joint venture as a partnership by making a qualified joint venture election.

A "qualified joint venture," whose only members are spouses filing a joint return, can elect not to be treated as a partnership for federal tax purposes. A qualified joint venture conducts a trade or business where the only members of the joint venture are spouses filing jointly; both spouses elect not to be treated as a partnership; both spouses materially participate in the trade or business (see Passive Activity Limitations in the Instructions for Form 1065 for a definition of material participation); and the business is co-owned by both spouses and is not held in the name of a state law entity such as a partnership or an LLC.

Under this election, a qualified joint venture conducted by spouses who file a joint return is not treated as a partnership for federal tax purposes and therefore doesn't have a Form 1065 filing requirement. All items of income, gain, deduction, loss, and credit are divided between the spouses based on their respective interests in the venture. Each spouse takes into account their respective share of these items as a sole proprietor. Each spouse would account for their respective share on the appropriate form, such as Schedule C (Form 1040). For purposes of determining net earnings from self-employment, each spouse's share of income or loss from a qualified joint venture is taken into account just as it is for federal income tax purposes (that is, based on their respective interests in the venture).

If the spouses do not make the election to treat their respective interests in the joint venture as sole proprietorships, each spouse should carry their share of the partnership income or loss from Schedule K-1 (Form 1065) to their joint or separate Form(s) 1040. Each spouse should include their respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax.

This generally doesn't increase the total tax on the return, but it does give each spouse credit for social security earnings on which retirement benefits are based. However, this may not be true if either spouse exceeds the social security tax limitation.

For more information on qualified joint ventures, go to IRS.gov/QJV .

The partnership agreement includes the original agreement and any modifications. The modifications must be agreed to by all partners or adopted in any other manner provided by the partnership agreement. The agreement or modifications can be oral or written.

Partners can modify the partnership agreement for a particular tax year after the close of the year but not later than the date for filing the partnership return for that year. This filing date doesn't include any extension of time.

If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part of the agreement.

Terminating a Partnership

A partnership terminates when all its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its partners in a partnership.

See Regulations section 1.708-1(b)(1) for more information on the termination of a partnership. For special rules that apply to a merger, consolidation, or division of a partnership, see Regulations sections 1.708-1(c) and 1.708-1(d).

The partnership's tax year ends on the date of termination. The date of termination is the date the partnership completes the winding up of its affairs.

If a partnership is terminated before the end of what would otherwise be its tax year, Form 1065 must be filed for the short period, which is the period from the beginning of the tax year through the date of termination. The return is due the 15 th day of the 3 rd month following the date of termination. See Partnership Return (Form 1065) , later, for information about filing Form 1065.

The conversion of a partnership into an LLC classified as a partnership for federal tax purposes doesn't terminate the partnership. The conversion is not a sale, exchange, or liquidation of any partnership interest; the partnership's tax year doesn't close; and the LLC can continue to use the partnership's taxpayer identification number (TIN).

However, the conversion may change some of the partners' bases in their partnership interests if the partnership has recourse liabilities that become nonrecourse liabilities. Because the partners share recourse and nonrecourse liabilities differently, their bases must be adjusted to reflect the new sharing ratios. If a decrease in a partner's share of liabilities exceeds the partner's basis, they must recognize gain on the excess. For more information, see Effect of Partnership Liabilities under Basis of Partner's Interest , later.

The same rules apply if an LLC classified as a partnership is converted into a partnership.

Certain partnerships with more than 100 partners are required to file Form 1065; Schedule K-1; and related forms and schedules electronically. For tax years beginning after July 1, 2019, a religious or apostolic organization exempt from income tax under section 501(d) must file Form 1065 electronically. Other partnerships generally have the option to file electronically. For details about electronic filing, see the Instructions for Form 1065.

Exclusion From Partnership Rules

Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being treated as partnerships for federal income tax purposes. All the partners must agree to make the choice, and the partners must be able to figure their own taxable income without figuring the partnership's income. However, the partners are not exempt from the rule that limits a partner's distributive share of partnership loss to the adjusted basis of the partner's partnership interest. Nor are they exempt from the requirement of a business purpose for adopting a tax year for the partnership that differs from its required tax year.

An investing partnership can be excluded if the participants in the joint purchase, retention, sale, or exchange of investment property meet all the following requirements.

They own the property as co-owners.

They reserve the right separately to take or dispose of their shares of any property acquired or retained.

They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange the investment property. Each separate participant can delegate authority to purchase, sell, or exchange their share of the investment property for the time being for their account, but not for a period of more than a year.

An operating agreement partnership group can be excluded if the participants in the joint production, extraction, or use of property meet all the following requirements.

They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights.

They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used.

They don't jointly sell services or the property produced or extracted. Each separate participant can delegate authority to sell their share of the property produced or extracted for the time being for their account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than 1 year.

An eligible organization that wishes to be excluded from the partnership rules must make the election not later than the time for filing the partnership return for the first tax year for which exclusion is desired. This filing date includes any extension of time. See Regulations section 1.761-2(b) for the procedures to follow.

Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. The partnership return must show the names and addresses of each partner and each partner's distributive share of taxable income. The return must be signed by a partner. If an LLC is treated as a partnership, it must file Form 1065 and one of its members must sign the return.

A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.

See the Instructions for Form 1065 for more information about who must file Form 1065.

Partnership Distributions

Partnership distributions include the following.

A withdrawal by a partner in anticipation of the current year's earnings.

A distribution of the current year's or prior years' earnings not needed for working capital.

A complete or partial liquidation of a partner's interest.

A distribution to all partners in a complete liquidation of the partnership.

A partnership distribution is not taken into account in determining the partner's distributive share of partnership income or loss. If any gain or loss from the distribution is recognized by the partner, it must be reported on their return for the tax year in which the distribution is received. Money or property withdrawn by a partner in anticipation of the current year's earnings is treated as a distribution received on the last day of the partnership's tax year.

A partner's adjusted basis in their partnership interest is decreased (but not below zero) by the money and adjusted basis of property distributed to the partner. See Adjusted Basis under Basis of Partner's Interest , later.

A partnership generally doesn't recognize any gain or loss because of distributions it makes to partners. The partnership may be able to elect to adjust the basis of its undistributed property.

When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property rather than a distribution.

Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's interest in other partnership property, including money.

Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or substantially appreciated inventory items.

See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest , later.

This treatment doesn't apply to the following distributions.

A distribution of property to the partner who contributed the property to the partnership.

Payments made to a retiring partner or successor in interest of a deceased partner that are the partner's distributive share of partnership income or guaranteed payments.

Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the distribution, their total FMV is more than 120% of the partnership's adjusted basis for the property. However, if a principal purpose for acquiring inventory property is to avoid ordinary income treatment by reducing the appreciation to less than 120%, that property is excluded.

Partner's Gain or Loss

A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner's interest in the partnership. Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. If partnership property (other than marketable securities treated as money) is distributed to a partner, they generally don't recognize any gain until the sale or other disposition of the property.

For exceptions to these rules, see Distribution of partner's debt and Net precontribution gain , later. Also, see Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest , later.

The adjusted basis of Jo's partnership interest is $14,000. She receives a distribution of $8,000 cash and land that has an adjusted basis of $2,000 and an FMV of $3,000. Because the cash received doesn't exceed the basis of her partnership interest, Jo doesn't recognize any gain on the distribution. Any gain on the land will be recognized when she sells or otherwise disposes of it. The distribution decreases the adjusted basis of Jo's partnership interest to $4,000 [$14,000 − ($8,000 + $2,000)].

If you held a qualified investment in a qualified opportunity fund (QOF) at any time during the year, you must file your return with Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments, attached. See the Form 8997 instructions.

Generally, a marketable security distributed to a partner is treated as money in determining whether gain is recognized on the distribution. This treatment, however, doesn't generally apply if that partner contributed the security to the partnership or an investment partnership made the distribution to an eligible partner.

The amount treated as money is the security's FMV when distributed, reduced (but not below zero) by the excess (if any) of:

The partner's distributive share of the gain that would be recognized had the partnership sold all its marketable securities at their FMV immediately before the transaction resulting in the distribution, over

The partner's distributive share of the gain that would be recognized had the partnership sold all such securities it still held after the distribution at the FMV in (1).

For more information, including the definition of marketable securities, see section 731(c).

A partner doesn't recognize loss on a partnership distribution unless all the following requirements are met.

The adjusted basis of the partner's interest in the partnership exceeds the distribution.

The partner's entire interest in the partnership is liquidated.

The distribution is in money, unrealized receivables, or inventory items.

There are exceptions to these general rules. See the following discussions. Also, see Liquidation at Partner's Retirement or Death under Disposition of Partner's Interest , later.

If a partnership acquires a partner's debt and extinguishes the debt by distributing it to the partner, the partner will recognize capital gain or loss to the extent the FMV of the debt differs from the basis of the debt (determined under the rules discussed under Partner's Basis for Distributed Property , later).

The partner is treated as having satisfied the debt for its FMV. If the issue price (adjusted for any premium or discount) of the debt exceeds its FMV when distributed, the partner may have to include the excess amount in income as canceled debt.

Similarly, a deduction may be available to a corporate partner if the FMV of the debt at the time of distribution exceeds its adjusted issue price.

A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution.

The gain recognized is the lesser of the following amounts.

The excess of:

The FMV of the property received in the distribution; over

The adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below zero) by any money received in the distribution.

The “net precontribution gain” of the partner. This is the net gain the partner would recognize if all the property contributed by the partner within 7 years of the distribution, and held by the partnership immediately before the distribution, were distributed to another partner, other than a partner who owns more than 50% of the partnership. For information about the distribution of contributed property to another partner, see Contribution of Property under Transactions Between Partnership and Partners , later.

The character of the gain is determined by reference to the character of the net precontribution gain. This gain is in addition to any gain the partner must recognize if the money distributed is more than their basis in the partnership.

For these rules, the term “money” includes marketable securities treated as money, as discussed earlier under Marketable securities treated as money .

The adjusted basis of the partner's interest in the partnership is increased by any net precontribution gain recognized by the partner. Other than for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. See Basis of Partner's Interest , later.

The partnership must adjust its basis in any property the partner contributed within 7 years of the distribution to reflect any gain that partner recognizes under this rule.

Any part of a distribution that is property the partner previously contributed to the partnership is not taken into account in determining the amount of the excess distribution or the partner's net precontribution gain. For this purpose, the partner's previously contributed property doesn't include a contributed interest in an entity to the extent its value is due to property contributed to the entity after the interest was contributed to the partnership.

Recognition of gain under this rule also doesn't apply to a distribution of unrealized receivables or substantially appreciated inventory items if the distribution is treated as a sale or exchange, as discussed earlier under Certain distributions treated as a sale or exchange .

Partner's Basis for Distributed Property

Unless there is a complete liquidation of a partner's interest, the basis of property (other than money) distributed to the partner by a partnership is its adjusted basis to the partnership immediately before the distribution. However, the basis of the property to the partner cannot be more than the adjusted basis of their interest in the partnership reduced by any money received in the same transaction.

The adjusted basis of Emily's partnership interest is $30,000. She receives a distribution of property that has an adjusted basis of $20,000 to the partnership and $4,000 in cash. Her basis for the property is $20,000.

The adjusted basis of Steve's partnership interest is $10,000. He receives a distribution of $4,000 cash and property that has an adjusted basis to the partnership of $8,000. His basis for the distributed property is limited to $6,000 ($10,000 − $4,000, the cash he receives).

The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's interest in the partnership reduced by any money distributed to the partner in the same transaction.

A partner's holding period for property distributed to the partner includes the period the property was held by the partnership. If the property was contributed to the partnership by a partner, then the period it was held by that partner is also included.

If the basis of property received is the adjusted basis of the partner's interest in the partnership (reduced by money received in the same transaction), it must be divided among the properties distributed to the partner. For property distributed after August 5, 1997, allocate the basis using the following rules.

Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to each item equal to the partnership's adjusted basis in the item immediately before the distribution. If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess.

Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each property equal to the partnership's adjusted basis in the property immediately before the distribution. If the allocable basis exceeds the total of these assigned bases, increase the assigned bases by the amount of the excess. If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess.

Allocate any basis increase required in rule (2) above first to properties with unrealized appreciation to the extent of the unrealized appreciation. If the basis increase is less than the total unrealized appreciation, allocate it among those properties in proportion to their respective amounts of unrealized appreciation. Allocate any remaining basis increase among all the properties in proportion to their respective FMVs.

Eun's basis in her partnership interest is $55,000. In a distribution in liquidation of her entire interest, she receives properties A and B, neither of which is inventory or unrealized receivables. Property A has an adjusted basis to the partnership of $5,000 and an FMV of $40,000. Property B has an adjusted basis to the partnership of $10,000 and an FMV of $10,000.

To figure her basis in each property, Eun first assigns bases of $5,000 to property A and $10,000 to property B (their adjusted bases to the partnership). This leaves a $40,000 basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned bases). She first allocates $35,000 to property A (its unrealized appreciation). The remaining $5,000 is allocated between the properties based on their FMVs. $4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is allocated to property B. Eun's basis in property A is $44,000 ($5,000 + $35,000 + $4,000) and her basis in property B is $11,000 ($10,000 + $1,000).

Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier.

Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. If the basis decrease is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of unrealized depreciation.

Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased in (1)).

Armando's basis in his partnership interest is $20,000. In a distribution in liquidation of his entire interest, he receives properties C and D, neither of which is inventory or unrealized receivables. Property C has an adjusted basis to the partnership of $15,000 and an FMV of $15,000. Property D has an adjusted basis to the partnership of $15,000 and an FMV of $5,000.

To figure his basis in each property, Armando first assigns bases of $15,000 to property C and $15,000 to property D (their adjusted bases to the partnership). This leaves a $10,000 basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable basis). He allocates the entire $10,000 to property D (its unrealized depreciation). Armando's basis in property C is $15,000 and his basis in property D is $5,000 ($15,000 − $10,000).

For property distributed before August 6, 1997, allocate the basis using the following rules.

Allocate the basis first to unrealized receivables and inventory items included in the distribution to the extent of the partnership's adjusted basis in those items. If the partnership's adjusted basis in those items exceeded the allocable basis, allocate the basis among the items in proportion to their adjusted bases to the partnership.

Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership.

If the basis of a partner's interest to be divided in a complete liquidation of the partner's interest is more than the partnership's adjusted basis for the unrealized receivables and inventory items distributed, and if no other property is distributed to which the partner can apply the remaining basis, the partner has a capital loss to the extent of the remaining basis of the partnership interest.

A partner who acquired any part of their partnership interest in a sale or exchange or upon the death of another partner may be able to choose a special basis adjustment for property distributed by the partnership. To choose the special adjustment, the partner must have received the distribution within 2 years after acquiring the partnership interest. Also, the partnership must not have chosen the optional adjustment to basis when the partner acquired the partnership interest.

If a partner chooses this special basis adjustment, the partner's basis for the property distributed is the same as it would have been if the partnership had chosen the optional adjustment to basis. However, this assigned basis is not reduced by any depletion or depreciation that would have been allowed or allowable if the partnership had previously chosen the optional adjustment.

The choice must be made with the partner's tax return for the year of the distribution if the distribution includes any property subject to depreciation, depletion, or amortization. If the choice doesn't have to be made for the distribution year, it must be made with the return for the first year in which the basis of the distributed property is pertinent in determining the partner's income tax.

A partner choosing this special basis adjustment must attach a statement to their tax return that the partner chooses under section 732(d) to adjust the basis of property received in a distribution. The statement must show the computation of the special basis adjustment for the property distributed and list the properties to which the adjustment has been allocated.

Chin Ho purchased a 25% interest in X partnership for $17,000 cash. At the time of the purchase, the partnership owned inventory having a basis to the partnership of $14,000 and an FMV of $16,000. Thus, $4,000 of the $17,000 he paid was attributable to his share of inventory with a basis to the partnership of $3,500.

Within 2 years after acquiring his interest, Chin Ho withdrew from the partnership and for his entire interest received cash of $1,500, inventory with a basis to the partnership of $3,500, and other property with a basis of $6,000. The value of the inventory received was 25% of the value of all partnership inventory. (It is immaterial whether the inventory he received was on hand when he acquired his interest.)

Because the partnership from which Chin Ho withdrew didn't make the optional adjustment to basis, he chose to adjust the basis of the inventory received. His share of the partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference between the $16,000 FMV of the inventory and its $14,000 basis to the partnership at the time he acquired his interest). The adjustment applies only for purposes of determining his new basis in the inventory, and not for purposes of partnership gain or loss on disposition.

The total to be allocated among the properties Chin Ho received in the distribution is $15,500 ($17,000 basis of his interest − $1,500 cash received). His basis in the inventory items is $4,000 ($3,500 partnership basis + $500 special adjustment). The remaining $11,500 is allocated to his new basis for the other property he received.

A partner doesn't always have a choice of making this special adjustment to basis. The special adjustment to basis must be made for a distribution of property (whether or not within 2 years after the partnership interest was acquired) if all the following conditions existed when the partner received the partnership interest.

The FMV of all partnership property (other than money) was more than 110% of its adjusted basis to the partnership.

If there had been a liquidation of the partner's interest immediately after it was acquired, an allocation of the basis of that interest under the general rules (discussed earlier under Basis divided among properties ) would have decreased the basis of property that couldn't be depreciated, depleted, or amortized and increased the basis of property that could be.

The optional basis adjustment, if it had been chosen by the partnership, would have changed the partner's basis for the property actually distributed.

Generally, if a partner chooses a special basis adjustment and notifies the partnership, or if the partnership makes a distribution for which the special basis adjustment is mandatory, the partnership must provide a statement to the partner. The statement must provide information necessary for the partner to figure the special basis adjustment.

A partner's basis in marketable securities received in a partnership distribution, as determined in the preceding discussions, is increased by any gain recognized by treating the securities as money. See Marketable securities treated as money under Partner’s Gain or Loss , earlier. The basis increase is allocated among the securities in proportion to their respective amounts of unrealized appreciation before the basis increase.

Transactions Between Partnership and Partners

For certain transactions between a partner and their partnership, the partner is treated as not being a member of the partnership. These transactions include the following.

Performing services for, or transferring property to, a partnership if:

There is a related allocation and distribution to a partner; and

The entire transaction, when viewed together, is properly characterized as occurring between the partnership and a partner not acting in the capacity of a partner.

Transferring money or other property to a partnership if:

There is a related transfer of money or other property by the partnership to the contributing partner or another partner, and

The transfers together are properly characterized as a sale or exchange of property.

A partnership that uses an accrual method of accounting cannot deduct any business expense owed to a cash basis partner until the amount is paid. However, this rule doesn't apply to guaranteed payments made to a partner, which are generally deductible when accrued.

Guaranteed Payments

Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. This treatment is for purposes of determining gross income and deductible business expenses only. For other tax purposes, guaranteed payments are treated as a partner's distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.

The partnership generally deducts guaranteed payments on Form 1065, line 10, as a business expense. They are also listed on Schedules K and K-1 of the partnership return. The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along with their distributive share of the partnership's other ordinary income.

Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. Generally, organizational and syndication expenses are not deductible by the partnership. However, a partnership can elect to deduct a portion of its organizational expenses and amortize the remaining expenses (see Business start-up and organizational costs in the Instructions for Form 1065 ). Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on the partners' Schedules K-1 as guaranteed payments.

If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the minimum payment is more than the partner's distributive share of the partnership income before taking into account the guaranteed payment.

Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. The partnership has net income of $20,000. Divya's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). Divya's income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement.

If the partnership net income had been $30,000, there would have been no guaranteed payment because her share, without regard to the guarantee, would have been greater than the guarantee.

Premiums for health insurance paid by a partnership on behalf of a partner, for services as a partner, are treated as guaranteed payments. The partnership can deduct the payments as a business expense, and the partner must include them in gross income. However, if the partnership accounts for insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums.

A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on their behalf as an adjustment to income. The partner cannot deduct the premiums for any calendar month, or part of a month, in which the partner is eligible to participate in any subsidized health plan maintained by any employer of the partner, the partner's spouse, the partner's dependents, or any children under age 27 who are not dependents. For more information on the self-employed health insurance deduction, see chapter 6 of Pub. 535.

Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends.

Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the guaranteed payment. She must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual income tax return for her tax year in which the partnership's tax year ends.

Lamont is a calendar year taxpayer who is a partner in a partnership. The partnership uses a fiscal year that ended January 31, 2021. Lamont received guaranteed payments from the partnership from February 1, 2020, until December 31, 2020. He must include these guaranteed payments in income for 2021 and report them on his 2021 income tax return.

If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report the full amount of the guaranteed payments as ordinary income. The partner separately takes into account their distributive share of the partnership loss, to the extent of the adjusted basis of the partner's partnership interest.

Sale or Exchange of Property

Special rules apply to a sale or exchange of property between a partnership and certain persons.

Losses will not be allowed from a sale or exchange of property (other than an interest in the partnership) directly or indirectly between a partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%.

If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than 50% of the capital or profits interests in each partnership, no deduction of a loss is allowed.

The basis of each partner's interest in the partnership is decreased (but not below zero) by the partner's share of the disallowed loss.

If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. If any gain from the sale of the property is not recognized because of this rule, the basis of each partner's interest in the partnership is increased by the partner's share of that gain.

Gains are treated as ordinary income in a sale or exchange of property directly or indirectly between a person and a partnership, or between two partnerships, if both of the following tests are met.

More than 50% of the capital or profits interest in the partnership(s) is directly or indirectly owned by the same person(s).

The property in the hands of the transferee immediately after the transfer is not a capital asset. Property that is not a capital asset includes accounts receivable, inventory, stock-in-trade, and depreciable or real property used in a trade or business.

To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply.

An interest directly or indirectly owned by, or for, a corporation, partnership, estate, or trust is considered to be owned proportionately by, or for, its shareholders, partners, or beneficiaries.

An individual is considered to own the interest directly or indirectly owned by, or for, the individual's family. For this rule, “family” includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants.

If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning that interest when rules (1) and (2) are applied. However, if a person is considered to own an interest using rule (2), that person is not treated as actually owning that interest in reapplying rule (2) to make another person the constructive owner.

Individuals A and B and Trust T are equal partners in Partnership ABT. A's husband, AH, is the sole beneficiary of Trust T. Trust T's partnership interest will be attributed to AH only for the purpose of further attributing the interest to A. As a result, A is a more-than-50% partner. This means that any deduction for losses on transactions between her and ABT will not be allowed, and gain from property that in the hands of the transferee is not a capital asset is treated as ordinary, rather than capital, gain.

For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Pub. 544.

Contribution of Property

Usually, neither the partner nor the partnership recognizes a gain or loss when property is contributed to the partnership in exchange for a partnership interest. This applies whether a partnership is being formed or is already operating. The partnership's holding period for the property includes the partner's holding period.

The contribution of limited partnership interests in one partnership for limited partnership interests in another partnership qualifies as a tax-free contribution of property to the second partnership if the transaction is made for business purposes. The exchange is not subject to the rules explained later under Disposition of Partner's Interest .

A contribution of money or other property to the partnership followed by a distribution of different property from the partnership to the partner is treated not as a contribution and distribution, but as a sale of property, if both of the following tests are met.

The distribution wouldn't have been made but for the contribution.

The partner's right to the distribution doesn't depend on the success of partnership operations.

All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized as a sale. However, if the contribution and distribution occur within 2 years of each other, the transfers are presumed to be a sale unless the facts clearly indicate that the transfers are not a sale. If the contribution and distribution occur more than 2 years apart, the transfers are presumed not to be a sale unless the facts clearly indicate that the transfers are a sale.

A partner must attach Form 8275, Disclosure Statement, (or other statement) to their return if the partner contributes property to a partnership and, within 2 years (before or after the contribution), the partnership transfers money or other consideration to the partner. For exceptions to this requirement, see Regulations section 1.707-3(c)(2).

A partnership must attach Form 8275 (or other statement) to its return if it distributes property to a partner, and, within 2 years (before or after the distribution), the partner transfers money or other consideration to the partnership.

Form 8275 must include the following information.

A caption identifying the statement as a disclosure under section 707.

A description of the transferred property or money, including its value.

A description of any relevant facts in determining if the transfers are properly viewed as a disguised sale. See Regulations section 1.707-3(b)(2) for a description of the facts and circumstances considered in determining if the transfers are a disguised sale.

Gain is recognized when property is contributed (in exchange for an interest in the partnership) to a partnership that would be treated as an investment company if it were incorporated.

A partnership is generally treated as an investment company if over 80% of the value of its assets is held for investment and consists of certain readily marketable items. These items include money, stocks and other equity interests in a corporation, and interests in regulated investment companies (RICs) and REITs. For more information, see section 351(e)(1) and the related regulations. Whether a partnership is treated as an investment company under this test is ordinarily determined immediately after the transfer of property.

This rule applies to limited partnerships and general partnerships, regardless of whether they are privately formed or publicly syndicated.

A domestic partnership that contributed property after August 5, 1997, to a foreign partnership in exchange for a partnership interest may have to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, if either of the following applies.

Immediately after the contribution, the partnership owned, directly, indirectly, or by attribution, at least a 10% interest in the foreign partnership.

The FMV of the property contributed to the foreign partnership, when added to other contributions of property made to the partnership during the preceding 12-month period, is greater than $100,000.

The partnership may also have to file Form 8865, even if no contributions are made during the tax year, if it owns a 10% or more interest in a foreign partnership at any time during the year. See the form instructions for more information.

If a partner contributes property to a partnership, the partnership's basis for determining depreciation, depletion, gain, or loss for the property is the same as the partner's adjusted basis for the property when it was contributed, increased by any gain recognized by the partner at the time of contribution.

The FMV of property at the time it is contributed may be different from the partner's adjusted basis. The partnership must allocate among the partners any income, deduction, gain, or loss on the property in a manner that will account for the difference. This rule also applies to contributions of accounts payable and other accrued but unpaid items of a cash basis partner.

The partnership can use different allocation methods for different items of contributed property. A single reasonable method must be consistently applied to each item, and the overall method or combination of methods must be reasonable. See Regulations section 1.704-3 for allocation methods generally considered reasonable.

If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner. If contributed property is subject to depreciation or other cost recovery, the allocation of deductions for these items takes into account built-in gain or loss on the property. However, the total depreciation, depletion, gain, or loss allocated to partners cannot be more than the depreciation or depletion allowable to the partnership or the gain or loss realized by the partnership.

Areta and Sofia formed an equal partnership. Areta contributed $10,000 in cash to the partnership and Sofia contributed depreciable property with an FMV of $10,000 and an adjusted basis of $4,000. The partnership's basis for depreciation is limited to the adjusted basis of the property in Sofia's hands, $4,000.

In effect, Areta purchased an undivided one-half interest in the depreciable property with her contribution of $10,000. Assuming that the depreciation rate is 10% a year under the General Depreciation System (GDS), she would have been entitled to a depreciation deduction of $500 per year, based on her interest in the partnership, if the adjusted basis of the property equaled its FMV when contributed. To simplify this example, the depreciation deductions are determined without regard to any first-year depreciation conventions.

However, because the partnership is allowed only $400 per year of depreciation (10% of $4,000), no more than $400 can be allocated between the partners. The entire $400 must be allocated to Areta.

If a partner contributes property to a partnership and the partnership distributes the property to another partner within 7 years of the contribution, the contributing partner must recognize gain or loss on the distribution.

The recognized gain or loss is the amount the contributing partner would have recognized if the property had been sold for its FMV when it was distributed. This amount is the difference between the property's basis and its FMV at the time of contribution. The character of the gain or loss will be the same as the character of the gain or loss that would have resulted if the partnership had sold the property to the distributee partner. Appropriate adjustments must be made to the adjusted basis of the contributing partner's partnership interest and to the adjusted basis of the property distributed to reflect the recognized gain or loss.

The following rules determine the character of the partnership's gain or loss on a disposition of certain types of contributed property.

Unrealized receivables. If the property was an unrealized receivable in the hands of the contributing partner, any gain or loss on its disposition by the partnership is ordinary income or loss. Unrealized receivables are defined later under Payments for Unrealized Receivables and Inventory Items . When reading the definition, substitute “partner” for “partnership.”

Inventory items. If the property was an inventory item in the hands of the contributing partner, any gain or loss on its disposition by the partnership within 5 years after the contribution is ordinary income or loss. Inventory items are defined later under Payments for Unrealized Receivables and Inventory Items .

Capital loss property. If the property was a capital asset in the contributing partner's hands, any loss on its disposition by the partnership within 5 years after the contribution is a capital loss. The capital loss is limited to the amount by which the partner's adjusted basis for the property exceeded the property's FMV immediately before the contribution.

Substituted basis property. If the disposition of any of the property listed in (1), (2), or (3) is a nonrecognition transaction, these rules apply when the recipient of the property disposes of any substituted basis property (other than certain corporate stock) resulting from the transaction.

Contribution of Services

A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed.

A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at FMV and the proceeds were distributed in a complete liquidation of the partnership. This determination is generally made at the time of receipt of the partnership interest. The FMV of such an interest received by a partner as compensation for services must generally be included in the partner's gross income in the first tax year in which the partner can transfer the interest or the interest is not subject to a substantial risk of forfeiture. The capital interest transferred as compensation for services is subject to the rules for restricted property discussed under Employee Compensation in Pub. 525, Taxable and Nontaxable Income.

The FMV of an interest in partnership capital transferred to a partner as payment for services to the partnership is a guaranteed payment, discussed earlier under Guaranteed Payments .

A profits interest is a partnership interest other than a capital interest. If a person receives a profits interest for providing services to, or for the benefit of, a partnership in a partner capacity or in anticipation of being a partner, the receipt of such an interest is not a taxable event for the partner or the partnership. However, this doesn't apply in the following situations.

The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease.

Within 2 years of receipt, the partner disposes of the profits interest.

The profits interest is a limited partnership interest in a publicly traded partnership.

A profits interest transferred as compensation for services is not subject to the rules for restricted property that apply to capital interests.

Basis of Partner's Interest

The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. If the partner must recognize gain as a result of the contribution, this gain is included in the basis of their interest. Any increase in a partner's individual liabilities because of an assumption of partnership liabilities is considered a contribution of money to the partnership by the partner.

If a partner acquires an interest in a partnership by gift, inheritance, or under any circumstance other than by a contribution of money or property to the partnership, the partner's basis must be determined using the basis rules described in Pub. 551.

Adjusted Basis

The basis of an interest in a partnership is increased or decreased by certain items.

A partner's basis is increased by the following items.

The partner's additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities.

The partner's distributive share of taxable and nontaxable partnership income.

The partner's distributive share of the excess of the deductions for depletion over the basis of the depletable property, unless the property is oil or gas wells whose basis has been allocated to partners.

The partner's basis is decreased (but never below zero) by the following items.

The money (including a decreased share of partnership liabilities or an assumption of the partner's individual liabilities by the partnership) and adjusted basis of property distributed to the partner by the partnership.

The partner's distributive share of the partnership losses (including capital losses).

The partner's distributive share of nondeductible partnership expenses that are not capital expenditures. This includes the partner's share of any section 179 expenses, even if the partner cannot deduct the entire amount on their individual income tax return.

The partner's deduction for depletion for any partnership oil and gas wells, up to the proportionate share of the adjusted basis of the wells allocated to the partner.

A partner’s distributive share of foreign taxes paid or accrued by the partnership for tax years beginning after 2017.

A partner’s distributive share of the adjusted basis of a partnership’s property donation to charity.

If the property’s FMV exceeds its adjusted basis, a special rule provides that the basis limitation on partner losses does not apply to the extent of the partner’s distributive share of the excess for tax years beginning after 2017.

If contributed property is subject to a debt or if a partner's liabilities are assumed by the partnership, the basis of that partner's interest is reduced (but not below zero) by the liability assumed by the other partners. This partner must reduce their basis because the assumption of the liability is treated as a distribution of money to that partner. The other partners' assumption of the liability is treated as a contribution by them of money to the partnership. See Effect of Partnership Liabilities , later.

Ivan acquired a 20% interest in a partnership by contributing property that had an adjusted basis to him of $8,000 and a $4,000 mortgage. The partnership assumed payment of the mortgage. The basis of Ivan's interest is:

If, in Example 1 , the contributed property had a $12,000 mortgage, the basis of Ivan's partnership interest would be zero. The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership interest. However, this gain wouldn't increase the basis of his partnership interest.

The adjusted basis of a partner's interest is determined without considering any amount shown in the partnership books as a capital, equity, or similar account.

Enzo contributes to his partnership property that has an adjusted basis of $400 and an FMV of $1,000. His partner contributes $1,000 cash. While each partner has increased his capital account by $1,000, which will be reflected in the partnership’s books, the adjusted basis of Enzo's interest is only $400 and the adjusted basis of his partner's interest is $1,000.

The adjusted basis of a partner's partnership interest is ordinarily determined at the end of the partnership's tax year. However, if there has been a sale or exchange of all or part of the partner's interest or a liquidation of their entire interest in a partnership, the adjusted basis is determined on the date of sale, exchange, or liquidation.

In certain cases, the adjusted basis of a partnership interest can be figured by using the partner's share of the adjusted basis of partnership property that would be distributed if the partnership terminated.

This alternative rule can be used in either of the following situations.

The circumstances are such that the partner cannot practicably apply the general basis rules.

It is, in the opinion of the IRS, reasonable to conclude that the result produced will not vary substantially from the result under the general basis rules.

Adjustments may be necessary in figuring the adjusted basis of a partnership interest under the alternative rule. For example, adjustments would be required to include in the partner's share of the adjusted basis of partnership property any significant discrepancies that resulted from contributed property, transfers of partnership interests, or distributions of property to the partners.

Effect of Partnership Liabilities

A partner's basis in a partnership interest includes the partner's share of a partnership liability only if, and to the extent that, the liability:

Creates or increases the partnership's basis in any of its assets;

Gives rise to a current deduction to the partnership; or

Is a nondeductible, noncapital expense of the partnership.

A partner's share of accrued but unpaid expenses or accounts payable of a cash basis partnership is not included in the adjusted basis of the partner's interest in the partnership.

If a partner's share of partnership liabilities increases, or a partner's individual liabilities increase because they assume partnership liabilities, this increase is treated as a contribution of money by the partner to the partnership.

If a partner's share of partnership liabilities decreases, or a partner's individual liabilities decrease because the partnership assumes their individual liabilities, this decrease is treated as a distribution of money to the partner by the partnership.

Generally, a partner or related person is considered to assume a partnership liability only to the extent that:

They’re personally liable for it,

The creditor knows that the liability was assumed by the partner or related person,

The creditor can demand payment from the partner or related person, and

No other partner or person related to another partner will bear the economic risk of loss on that liability immediately after the assumption.

Related persons, for these purposes, includes all the following.

An individual and their spouse, ancestors, and lineal descendants.

An individual and a corporation if the individual directly or indirectly owns 80% or more in value of the outstanding stock of the corporation.

Two corporations that are members of the same controlled group.

A grantor and a fiduciary of any trust.

Fiduciaries of two separate trusts if the same person is a grantor of both trusts.

A fiduciary and a beneficiary of the same trust.

A fiduciary and a beneficiary of two separate trusts if the same person is a grantor of both trusts.

A fiduciary of a trust and a corporation if the trust or the grantor of the trust directly or indirectly owns 80% or more in value of the outstanding stock of the corporation.

A person and a tax-exempt educational or charitable organization controlled directly or indirectly by the person or by members of the person's family.

A corporation and a partnership if the same persons own 80% or more in value of the outstanding stock of the corporation and 80% or more of the capital or profits interest in the partnership.

Two S corporations or an S corporation and a C corporation if the same persons own 80% or more in value of the outstanding stock of each corporation.

An executor and a beneficiary of an estate.

A partnership and a person owning, directly or indirectly, 80% or more of the capital or profits interest in the partnership.

Two partnerships if the same persons directly or indirectly own 80% or more of the capital or profits interests.

If property contributed to a partnership by a partner or distributed by the partnership to a partner is subject to a liability, the transferee is treated as having assumed the liability to the extent it doesn't exceed the FMV of the property.

A partnership liability is a recourse liability to the extent that any partner or a related person, defined earlier under Related person , has an economic risk of loss for that liability. A partner's share of a recourse liability equals their economic risk of loss for that liability. A partner has an economic risk of loss if that partner or a related person would be obligated (whether by agreement or law) to make a net payment to the creditor or a contribution to the partnership with respect to the liability if the partnership were constructively liquidated. A partner who is the creditor for a liability that would otherwise be a nonrecourse liability of the partnership has an economic risk of loss in that liability.

Generally, in a constructive liquidation, the following events are treated as occurring at the same time.

All partnership liabilities become payable in full.

All of the partnership's assets have a value of zero, except for property contributed to secure a liability.

All property is disposed of by the partnership in a fully taxable transaction for no consideration except relief from liabilities for which the creditor's right to reimbursement is limited solely to one or more assets of the partnership.

All items of income, gain, loss, or deduction are allocated to the partners.

The partnership liquidates.

Juan and Teresa form a cash basis general partnership with cash contributions of $20,000 each. Under the partnership agreement, they share all partnership profits and losses equally. The partnership borrows $60,000 and purchases depreciable business equipment. This debt is included in the partners' basis in the partnership because incurring it creates an additional $60,000 of basis in the partnership's depreciable property.

If neither partner has an economic risk of loss in the liability, it is a nonrecourse liability. Each partner's basis would include their share of the liability, $30,000.

If Teresa is required to pay the creditor if the partnership defaults, she has an economic risk of loss in the liability. Her basis in the partnership would be $80,000 ($20,000 + $60,000), while Juan's basis would be $20,000.

A limited partner generally has no obligation to contribute additional capital to the partnership and therefore doesn't have an economic risk of loss in partnership recourse liabilities. Thus, absent some other factor, such as the guarantee of a partnership liability by the limited partner or the limited partner making the loan to the partnership, a limited partner generally doesn't have a share of partnership recourse liabilities.

A partnership liability is a nonrecourse liability if no partner or related person has an economic risk of loss for that liability. A partner's share of nonrecourse liabilities is generally proportionate to their share of partnership profits. However, this rule may not apply if the partnership has taken deductions attributable to nonrecourse liabilities or the partnership holds property that was contributed by a partner.

For more information on the effect of partnership liabilities, including rules for limited partners and examples, see Regulations sections 1.752-1 through 1.752-5.

Disposition of Partner's Interest

The following discussions explain the treatment of gain or loss from the disposition of an interest in a partnership.

A loss incurred from the abandonment or worthlessness of a partnership interest is an ordinary loss only if both of the following tests are met.

The transaction is not a sale or exchange.

The partner has not received an actual or deemed distribution from the partnership.

For information on how to report an abandonment loss, see the Instructions for Form 4797. See Revenue Ruling 93-80 for more information on determining if a loss incurred on the abandonment or worthlessness of a partnership interest is a capital or an ordinary loss.

Generally, a partnership's basis in its assets is not affected by a transfer of an interest in the partnership, whether by sale or exchange or because of the death of a partner. However, the partnership can elect to make an optional adjustment to basis in the year of transfer.

Sale, Exchange, or Other Transfer

The sale or exchange of a partner's interest in a partnership usually results in capital gain or loss. However, see Payments for Unrealized Receivables and Inventory Items , later, for certain exceptions. Gain or loss is the difference between the amount realized and the adjusted basis of the partner's interest in the partnership. If the selling partner is relieved of any partnership liabilities, that partner must include the liability relief as part of the amount realized for their interest.

Kumar became a limited partner in the ABC Partnership by contributing $10,000 in cash on the formation of the partnership. The adjusted basis of his partnership interest at the end of the current year is $20,000, which includes his $15,000 share of partnership liabilities. The partnership has no unrealized receivables or inventory items. Kumar sells his interest in the partnership for $10,000 in cash. He had been paid his share of the partnership income for the tax year.

Kumar realizes $25,000 from the sale of his partnership interest ($10,000 cash payment + $15,000 liability relief). He reports $5,000 ($25,000 realized − $20,000 basis) as a capital gain.

The facts are the same as in Example 1 , except that Kumar withdraws from the partnership when the adjusted basis of his interest in the partnership is zero. He is considered to have received a distribution of $15,000, his relief of liability. He reports a capital gain of $15,000.

A partner who sells a partnership interest at a gain may be able to report the sale on the installment method. For requirements and other information on installment sales, see Pub. 537.

Part of the gain from the installment sale may be allocable to unrealized receivables or inventory items. See Payments for Unrealized Receivables and Inventory Items next. The gain allocable to unrealized receivables and inventory items must be reported in the year of sale. The gain allocable to the other assets can be reported under the installment method.

Payments for Unrealized Receivables and Inventory Items

If a partner receives money or property in exchange for any part of a partnership interest, the amount due to their share of the partnership's unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset.

This treatment applies to the unrealized receivables part of payments to a retiring partner or successor in interest of a deceased partner only if that part is not treated as paid in exchange for partnership property. See Liquidation at Partner's Retirement or Death , later.

Unrealized receivables include any rights to payment not already included in income for the following items.

Goods delivered or to be delivered to the extent the payment would be treated as received for property other than a capital asset.

Services rendered or to be rendered.

These rights must have arisen under a contract or agreement that existed at the time of sale or distribution, even though the partnership may not be able to enforce payment until a later date. For example, unrealized receivables include accounts receivable of a cash method partnership and rights to payment for work or goods begun but incomplete at the time of the sale or distribution of the partner's share.

The basis for any unrealized receivables includes all costs or expenses for the receivables that were paid or accrued but not previously taken into account under the partnership's method of accounting.

Unrealized receivables include potential gain that would be ordinary income if the following partnership property were sold at its FMV on the date of the payment.

Mining property for which exploration expenses were deducted.

Stock in a domestic international sales corporation (DISC).

Certain farmland for which expenses for soil and water conservation or land clearing were deducted.

Franchises, trademarks, or trade names.

Oil, gas, or geothermal property for which intangible drilling and development costs were deducted.

Stock of certain controlled foreign corporations.

Market discount bonds and short-term obligations.

Property subject to recapture of depreciation under sections 1245 and 1250. Depreciation recapture is discussed in chapter 3 of Pub. 544.

The income or loss realized by a partner upon the sale or exchange of its interest in unrealized receivables and inventory items, discussed below, is the amount that would have been allocated to the partner if the partnership had sold all of its property for cash at FMV, in a fully taxable transaction, immediately prior to the partner's transfer of interest in the partnership. Any gain or loss recognized that is attributable to the unrealized receivables and inventory items will be ordinary gain or loss.

You are a partner in ABC Partnership. The adjusted basis of your partnership interest at the end of the current year is zero. Your share of potential ordinary income from partnership depreciable property is $5,000. The partnership has no other unrealized receivables or inventory items. You sell your interest in the partnership for $10,000 in cash and you report the entire amount as a gain because your adjusted basis in the partnership is zero. You report as ordinary income your $5,000 share of potential ordinary income from the partnership's depreciable property. The remaining $5,000 gain is a capital gain.

Inventory items are not limited to stock-in-trade of the partnership. They also include the following property.

Property that would properly be included in the partnership's inventory if on hand at the end of the tax year or that is held primarily for sale to customers in the normal course of business.

Property that, if sold or exchanged by the partnership, wouldn't be a capital asset or section 1231 property (real or depreciable business property held more than 1 year). For example, accounts receivable acquired for services or from the sale of inventory and unrealized receivables are inventory items.

Property held by the partnership that would be considered inventory if held by the partner selling the partnership interest or receiving the distribution.

If a partner exchanges a partnership interest attributable to unrealized receivables or inventory for money or property, they must notify the partnership in writing. This must be done within 30 days of the transaction or, if earlier, by January 15 of the calendar year following the calendar year of the exchange. A partner may be subject to a $50 penalty for each failure to notify the partnership about such a transaction, unless the failure was due to reasonable cause and not willful neglect.

When a partnership is notified of an exchange of partnership interests involving unrealized receivables or inventory items, the partnership must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests. Form 8308 is filed with Form 1065 for the tax year that includes the last day of the calendar year in which the exchange took place. If notified of an exchange after filing Form 1065, the partnership must file Form 8308 separately, within 30 days of the notification.

On Form 8308, the partnership provides its telephone number and states the date of the exchange and the names, addresses, and TINs of the partnership filing the return and the transferee and transferor in the exchange. The partnership must provide a copy of Form 8308 (or a written statement with the same information) to each transferee and transferor by the later of January 31 following the end of the calendar year or 30 days after it receives notice of the exchange.

The partnership may be subject to a penalty for each failure to timely file Form 8308 and a penalty for each failure to furnish a copy of Form 8308 to a transferor or transferee, unless the failure is due to reasonable cause and not willful neglect. If the failure is intentional, a higher penalty may be imposed. See sections 6722, 6723, and 6724 for details.

If a partner sells or exchanges any part of an interest in a partnership having unrealized receivables or inventory, they must file a statement with their tax return for the year in which the sale or exchange occurs. The statement must contain the following information.

The date of the sale or exchange.

The amount of any gain or loss attributable to the unrealized receivables or inventory.

The amount of any gain or loss attributable to capital gain or loss on the sale of the partnership interest.

In general, any gain or loss on a sale or exchange of unrealized receivables or inventory items a partner received in a distribution is an ordinary gain or loss. For this purpose, inventory items do not include real or depreciable business property, even if they are not held more than 1 year.

Oscar, a distributee partner, received his share of accounts receivable when his law firm dissolved. The partnership used the cash method of accounting, so the receivables had a basis of zero. If Oscar later collects the receivables or sells them, the amount he receives will be ordinary income.

If a distributee partner sells inventory items held for more than 5 years after the distribution, the type of gain or loss depends on how they are being used on the date sold. The gain or loss is capital gain or loss if the property is a capital asset in the partner's hands at the time sold.

Marucia receives, through dissolution of her partnership, inventory that has a basis of $19,000. Within 5 years, she sells the inventory for $24,000. The $5,000 gain is taxed as ordinary income. If she had held the inventory for more than 5 years, her gain would have been capital gain, provided the inventory was a capital asset in her hands at the time of sale.

If a distributee partner disposes of unrealized receivables or inventory items in a nonrecognition transaction, ordinary gain or loss treatment applies to a later disposition of any substituted basis property resulting from the transaction.

Section 864(c)(8) requires a foreign partner that transfers part or all of an interest in a partnership engaged in the conduct of a trade or business in the United States (U.S. trade or business) to include in income the effectively connected gain or loss from the transfer. A partnership distribution is considered a transfer when it results in recognition of gain or loss. See Regulations section 1.731-1(a).

In general, any foreign person, any domestic partnership that has a foreign person as a direct partner, and any domestic partnership that has actual knowledge that a foreign person indirectly holds, through one or more partnerships, an interest in the domestic partnership that transfers an interest in a partnership engaged in a U.S. trade or business must notify the partnership of the transfer in writing within 30 days after the transfer. The notification must include:

The names and addresses of the notifying transferor and the transferee or transferees;

The U.S. TIN of the notifying transferor and, if known, of the transferee or transferees; and

The date of the transfer.

This notification requirement does not apply to the transfer of an interest in a publicly traded partnership if the interest is publicly traded on an established securities market or is readily tradable on a secondary market (or the substantial equivalent thereof). It also does not apply to a notifying transferor that is treated as transferring an interest in the partnership because it received a distribution from the partnership. This notification may be combined with or provided at the same time as the statement required of a partner that sells or exchanges any part of an interest in a partnership having unrealized receivables or inventory, provided that it satisfies the requirements of both sections. For more information, see Regulations section 1.864(c)(8)-2.

To determine the amount of gain or loss described in section 864(c)(8), generally, a foreign transferor must first determine its outside gain or loss on the transfer of a partnership interest. For this purpose, outside gain or loss is determined under all relevant provisions of the Code and regulations thereunder. A foreign transferor may recognize outside capital gain or loss and outside ordinary gain or loss on the transfer of its partnership interest and must separately apply section 864(c)(8) with respect to its capital gain or loss and its ordinary gain or loss.

The foreign transferor must compare the outside gain or loss amounts with the relevant aggregate deemed sale effectively connected gain or loss that the partnership calculates based on the foreign transferor's distributive share of gain or loss that would have been effectively connected if the partnership had sold all of its assets at FMV. This information will be provided to the notifying transferor on or before the due date (with extensions) for issuing Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc. The foreign transferor only includes in income the lower of the outside amount and the deemed sale effectively connected amount. This determination is made separately with respect to capital gain or loss and ordinary gain or loss. For example, a foreign transferor would compare its outside ordinary gain to its aggregate deemed sale effectively connected ordinary gain, treating the former as effectively connected gain only to the extent it does not exceed the latter. For more information, see Regulations section 1.864(c)(8)-1.

Liquidation at Partner's Retirement or Death

Payments made by the partnership to a retiring partner or successor in interest of a deceased partner in return for the partner's entire interest in the partnership may have to be allocated between payments in liquidation of the partner's interest in partnership property and other payments. The partnership's payments include an assumption of the partner's share of partnership liabilities treated as a distribution of money.

For income tax purposes, a retiring partner or successor in interest of a deceased partner is treated as a partner until their interest in the partnership has been completely liquidated.

Payments made in liquidation of the interest of a retiring or deceased partner in exchange for their interest in partnership property are considered a distribution, not a distributive share or guaranteed payment that could give rise to a deduction (or its equivalent) for the partnership.

Payments made for the retiring or deceased partner's share of the partnership's unrealized receivables or goodwill are not treated as made in exchange for partnership property if both of the following tests are met.

Capital is not a material income-producing factor for the partnership. Whether capital is a material income-producing factor is explained under Partnership Interests Created by Gift , earlier.

The retiring or deceased partner was a general partner in the partnership.

Unrealized receivables include, to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for (1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset; or (2) services rendered, or to be rendered.

Generally, the partners' valuation of a partner's interest in partnership property in an arm's-length agreement will be treated as correct. If the valuation reflects only the partner's net interest in the property (total assets less liabilities), it must be adjusted so that both the value of, and the basis for, the partner's interest include the partner's share of partnership liabilities.

Upon the receipt of the distribution, the retiring partner or successor in interest of a deceased partner will recognize gain only to the extent that any money (and marketable securities treated as money) distributed is more than the partner's adjusted basis in the partnership. The partner will recognize a loss only if the distribution is in money, unrealized receivables, and inventory items. No loss is recognized if any other property is received. See Partner's Gain or Loss under Partnership Distributions , earlier.

Payments made by the partnership to a retiring partner or successor in interest of a deceased partner that are not made in exchange for an interest in partnership property are treated as distributive shares of partnership income or guaranteed payments. This rule applies regardless of the time over which the payments are to be made. It applies to payments made for the partner's share of unrealized receivables and goodwill not treated as a distribution.

If the amount is based on partnership income, the payment is taxable as a distributive share of partnership income. The payment retains the same character when reported by the recipient that it would have had if reported by the partnership.

If the amount is not based on partnership income, it is treated as a guaranteed payment. The recipient reports guaranteed payments as ordinary income. For additional information on guaranteed payments, see Transactions Between Partnership and Partners , earlier.

These payments are included in income by the recipient for their tax year that includes the end of the partnership tax year for which the payments are a distributive share or in which the partnership is entitled to deduct them as guaranteed payments.

Former partners who continue to make guaranteed periodic payments to satisfy the partnership's liability to a retired partner after the partnership is terminated can deduct the payments as a business expense in the year paid.

Section 1061 Reporting Instructions

The instructions for owner taxpayer filing requirements and pass-through entity filing and reporting requirements are in accordance with Regulations section 1.1061-6. For more information, see T.D. 9945, 2021-5, I.R.B. 627, available at IRS.gov/irb/2021-5_IRB#TD-9945 , for specific rules and definitions.

Pass-Through Entity Reporting to API Holders

A pass-through entity is required to attach Worksheet A to the API holder’s Schedule K-1 for tax returns filed after December 31, 2021, in which a pass-through entity applies the final regulations under T.D. 9945. A pass-through entity means a partnership, trust, estate, S corporation described in Regulations section 1.1061-3(b)(2)(i), or a passive foreign investment company (PFIC) described in Regulations section 1.1061-3(b)(2)(ii). The pass-through entity must provide the information in Worksheet A to each API holder, including owner taxpayer, as an attachment to the Schedule K-1 for the applicable form, noting the proper box and code. For the 2021 Form 1065, it’s box 20, code AH. For the 2021 Form 1120-S, U.S. Income Tax Return for an S Corporation, it’s box 17, code AD. For the 2021 Form 1041, U.S. Income Tax Return for Estate and Trusts, it’s box 14, code Z

See Regulations section 1.1061-6(c) for the section 1061 reporting rules of a RIC and a REIT. In the case of RICs and REITs, the information will be furnished in connection with the Form 1099-DIV, Dividends and Distributions.

Regulations section 1.1061-6(d) permits a PFIC with respect to which the shareholder is an API holder who has a qualified electing fund election (as described in section 1295(a)) in effect for the tax year to provide additional information to the shareholder to determine the amount of the shareholder's inclusion that would be included in the Section 1061 Worksheet A: API 1-Year Distributive Share Amount and API 3-Year Distributive Share Amount. If the PFIC furnishes this information to the shareholder, the shareholder must retain a copy of this information along with the other information required to be retained under Regulations section 1.1295-1(f)(2)(ii).

A pass-through entity that is not required to and does not choose to apply the final regulations to tax returns filed after December 31, 2021, for a tax year beginning before January 19, 2021, must attach a worksheet to the API holder's Schedule K-1 that contains similar information as Worksheet A , and must disclose whether the information was determined under the proposed regulations or another method.

Section 1061 Worksheet A .

Owner Taxpayer Calculation of Amount Treated as Short-Term Capital Gain Under Section 1061

An owner taxpayer is the person who is subject to federal income tax on the recharacterization amount, and could be an individual, estate, or trust. An owner taxpayer uses information provided by all the pass-through entities in which it holds an API, directly or indirectly, to determine the amount that is recharacterized as short-term capital gain under sections 1061(a) and (d) for a tax year. For tax returns filed after December 31, 2021, in which an owner taxpayer applies the final regulations under T.D. 9945, Worksheet B must be used to determine the amount of the owner taxpayer’s recharacterization amount. Worksheet B , along with Table 1 and Table 2 , are to be attached to the owner taxpayer’s tax return.

An owner taxpayer that is not required to and does not choose to apply the final regulations to tax returns filed after December 21, 2021, for a tax year beginning before January 19, 2021, must attach worksheets to its return that contain similar information as Worksheet B , Table 1 , and Table 2 ; and must disclose whether the information was determined under proposed regulations or another method.

Section 1061 Worksheet B .

Section 1061 Table 1: API 1-Year Disposition Amount .

Section 1061 Table 2: API 3-Year Disposition Amount .

An owner taxpayer reports long- and short-term API gains and losses on Schedule D (Form 1040) or Schedule D (Form 1041) and on Form 8949, Sales and Other Dispositions of Capital Assets, as if section 1061 does not apply. In addition, if the owner taxpayer has a recharacterization amount as computed on line 7 of Worksheet B, and/or any amounts resulting from the application of section 1061(d) (transfer of an API to a related person) on line 8 of Worksheet B (see Regulations section 1.1061-5(c)), the owner taxpayer will increase the reported short-term capital gain by listing as a transaction identified as "Section 1061 Adjustment" on Form 8949, Part I, line 1, column (a), and entering the amount from line 9 of Worksheet B as proceeds (column (d) of the Form 8949) and zero as basis (column (e) of the Form 8949). The owner taxpayer will make corresponding entries on Form 8949, Part II, line 1, to reduce the reported long-term capital gain by listing as a transaction identified as "Section 1061 Adjustment" in column (a) of the Form 8949 and entering zero as proceeds (column (d) of the Form 8949) and the amount from line 9 of Worksheet B as basis (column (e) of the Form 8949).

The Owner Taxpayer Reporting of Collectibles Gain and Unrecaptured Section 1250 Gain

Pending further guidance, if the owner taxpayer sells an API and recognizes collectibles gain or loss or unrecaptured section 1250 gain, or if a pass-through entity reports that collectibles gain or loss or unrecaptured section 1250 gain is treated as API gain or loss, the owner taxpayer must use a reasonable method to compute the amount of the inclusion of collectibles gain and/or unrecaptured section 1250 gain in the recharacterization amount that is calculated in Worksheet B. If the owner taxpayer has received an API 1-year distributive share amount and an API 3-year distributive share amount that includes collectibles gain or loss and/or unrecaptured section 1250 gain from a pass-through entity, the owner taxpayer should include those amounts on lines 1 and 4, respectively, of Worksheet B. If the owner taxpayer has received an API 1-year distributive share amount and an API 3-year distributive share amount that includes collectibles gain or loss and/or unrecaptured section 1250 gain from a pass-through entity, the owner taxpayer should include those amounts on lines 1 and 4, respectively, of Worksheet B .

On line 10 of Worksheet B , the owner taxpayer must report the total amount of collectibles gains for the tax year that the owner taxpayer has with respect to any interest in a pass-through entity (pass-through interests) that it owns. It must also report the amount of collectibles gain that is recharacterized as short-term capital gain under section 1061 and the amount of collectibles gain that is not recharacterized and that is included in the 28% Rate Gain Worksheet (see line 18 of the Schedule D (Form 1040), or line 18c of the Schedule D (Form 1041)). Collectibles gain or loss that is API gain or loss and is included in the calculation of the recharacterization amount, but not recharacterized, must be included in the 28% Rate Gain Worksheet. Collectibles gain or loss with respect to a pass-through interest that is treated as capital interest gain or loss must also be included in the 28% Rate Gain Worksheet.

Similarly, on line 11 of Worksheet B , the owner taxpayer must report the total amount of unrecaptured section 1250 gain for the tax year that the owner taxpayer has with respect to any pass-through interests that it owns. It must also report the amount of unrecaptured section 1250 gain that is recharacterized as short-term capital gain under section 1061 and the amount of unrecaptured section 1250 gain that is not recharacterized and that is included in the Unrecaptured Section 1250 Gain Worksheet (see line 19 of the Schedule D (Form 1040), or line 18b of the Schedule D (Form 1041)). Unrecaptured section 1250 gain or loss that is API gain or loss and is included in the calculation of the recharacterization amount, but not recharacterized, must be included in the Unrecaptured Section 1250 Gain Worksheet. Unrecaptured section 1250 gain or loss with respect to a pass-through interest that is treated as capital interest gain or loss must also be included in the Unrecaptured Section 1250 Gain Worksheet.

Owner Taxpayer M, an individual, holds an API in XYZ Partnership and receives a Schedule K-1 with Worksheet A attached from XYZ Partnership for the tax year 2021, that contains a long-term capital gain of $55,000 in box 9a of the Schedule K-1. Taxpayer M did not dispose of an API in 2021. The following is a summary of Worksheet A that XYZ Partnership attached to Taxpayer M's Schedule K-1: Line 4 has an API 1-year distributive share amount of $55,000 and line 7 has an API 3-year distributive share amount of $20,000.

Taxpayer M reports a $55,000 long-term capital gain from XYZ Partnership on Schedule D (Form 1040), line 12. Taxpayer M chose to follow the final regulations under T.D. 9945 in preparation of their 2021 tax return and prepares and attaches Worksheet B to their Form 1040. Worksheet B has a 1-year gain amount on line 3 of $55,000, a 3-year gain amount of $20,000 on line 6, a recharacterization amount on line 7 of $35,000, and a section 1061 adjustment on line 9 of $35,000. In addition to reporting the long-term capital gain of $55,000 on Schedule D (Form 1040), line 12, Taxpayer M reports on Form 8949, Part I, line 1, a short-term capital gain of $35,000, and on Part II, line 1, a long-term capital loss of ($35,000). Both Form 8949 items are described in column (a) as "Section 1061 Adjustment."

TEFRA is the common acronym used for a set of consolidated examination, processing, and judicial procedures which determine the tax treatment of partnership items at the partnership level for partnerships and LLCs that file as partnerships. TEFRA created the unified partnership audit and litigation procedures (TEFRA partnership procedures) of sections 6221 through 6234 (prior to the amendments by the BBA). For additional information on TEFRA partnership procedures, see the January 2016 revision of Pub. 541.

Bipartisan Budget Act of 2015 (BBA)

The BBA created a new centralized partnership audit regime effective for partnership tax years beginning after 2017. The new regime replaces the consolidated audit proceedings under TEFRA and the electing large partnership provisions. The new audit regime applies to all partnerships unless the partnership is an eligible partnership and elects out by making a valid election. See the Instructions for Form 1065 and BBA Centralized Partnership Audit Regime .

Under the centralized partnership audit regime, partnerships are required to designate a partnership representative. The partnership representative will have the sole authority to act on behalf of the partnership under the centralized partnership audit regime. The designated partnership representative is a partner or other person with substantial presence in the United States. If the designated partnership representative is an entity, the partnership must also appoint a designated individual to act on behalf of the entity partnership representative. The partnership must include information regarding the partnership representative and designated individual (if applicable) on Form 1065, Schedule B. For more information, see the Instructions for Form 1065.

A partnership can elect out of the centralized partnership audit regime for a tax year if the partnership is an eligible partnership that year. A partnership is an eligible partnership for a tax year if it has 100 or fewer eligible partners. A partner is an eligible partner if it is an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were domestic, an S corporation, or an estate of a deceased partner. The determination as to whether the partnership has 100 or fewer partners is made by adding the number of Schedules K-1 required to be issued by the partnership to the number of Schedules K-1 required to be issued by any partner that is an S corporation to its shareholders for the tax year of the S corporation ending with or within the partnership tax year. A partnership is not an eligible partnership if it is required to issue a Schedule K-1 to any of the following partners.

A partnership.

A foreign entity that would not be treated as a C corporation were it a domestic entity.

A disregarded entity described in Regulations section 301.7701-2(c)(2)(i).

An estate of an individual other than a deceased partner.

Any person that holds an interest in the partnership on behalf of another person. See the Instructions for Form 1065 if electing out of the centralized partnership audit regime.

An annual election out of the centralized partnership audit regime must be made on the eligible partnership’s timely filed return, including extensions, for the tax year to which the election applies. The election is made by including the following information on Schedule B-2 (Form 1065) and filing with the tax return.

The name of each partner.

The TIN of each partner.

The federal tax classification for each partner.

If an S corporation is a partner, provide the names, TINs, and federal tax classification of any shareholder of the S corporation for the tax year of the S corporation ending with or within the partnership’s tax year.

This annual election once made may not be revoked without the consent of the IRS. A partnership that elects out of the centralized partnership audit regime must notify each of its partners of the election within 30 days of making the election. By making the election out of the centralized partnership audit regime, you are affirming that all of the partners in the partnership meet the eligibility requirements under section 6221(b)(1)(C) and you have provided all of the required information with the Form 1065.

Administrative Adjustment Request

Rather than filing an amended return, a partnership that is subject to the centralized partnership audit regime must file an Administrative Adjustment Request (AAR) to change the amount or treatment of one or more partnership-related items. If filing electronically, file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), with a Form 1065, or Form 1065-X, Amended Return or Administrative Adjustment Request (AAR).

Partnerships subject to the centralized partnership audit regime and filing an AAR that results in an imputed underpayment and any interest or penalties related to the imputed underpayment should report the imputed underpayment and any related interest and penalties on Form 1065 or 1065-X (as applicable). See the Instructions for Form 1065.

See the instructions for Form 8082 or 1065-X (as applicable) for the following.

Information pertaining to certain modifications that are allowable for the partnership to include in its calculation of an AAR imputed underpayment.

Information pertaining to the ability for the partnership to make an election under section 6227(b)(2) to have the adjustments of the AAR taken into account by the reviewed year partners, rather than the partnership making an imputed underpayment.

Section 6225(c) allows a BBA partnership under examination to request specific types of modifications of any imputed underpayment proposed by the IRS. One type of modification (under section 6225(c)(2)) that may be requested is when one or more (reviewed year) partners file amended returns for the tax years of the partners which includes the end of the reviewed year of the BBA partnership under examination and for any tax year with respect to which tax attributes are affected. See the Instructions for Form 8980.

How To Get Tax Help

If you have questions about a tax issue; need help preparing your tax return; or want to download free publications, forms, or instructions, go to IRS.gov to find resources that can help you right away.

After receiving all your wage and earnings statements (Forms W-2, W-2G, 1099-R, 1099-MISC, 1099-NEC, etc.); unemployment compensation statements (by mail or in a digital format) or other government payment statements (Form 1099-G); and interest, dividend, and retirement statements from banks and investment firms (Forms 1099), you have several options to choose from to prepare and file your tax return. You can prepare the tax return yourself, see if you qualify for free tax preparation, or hire a tax professional to prepare your return.

Go to IRS.gov to see your options for preparing and filing your return online or in your local community, if you qualify, which include the following.

Free File. This program lets you prepare and file your federal individual income tax return for free using brand-name tax-preparation-and-filing software or Free File fillable forms. However, state tax preparation may not be available through Free File. Go to IRS.gov/FreeFile to see if you qualify for free online federal tax preparation, e-filing, and direct deposit or payment options.

VITA. The Volunteer Income Tax Assistance (VITA) program offers free tax help to people with low-to-moderate incomes, persons with disabilities, and limited-English-speaking taxpayers who need help preparing their own tax returns. Go to IRS.gov/VITA , download the free IRS2Go app, or call 800-906-9887 for information on free tax return preparation.

TCE. The Tax Counseling for the Elderly (TCE) program offers free tax help for all taxpayers, particularly those who are 60 years of age and older. TCE volunteers specialize in answering questions about pensions and retirement-related issues unique to seniors. Go to IRS.gov/TCE , download the free IRS2Go app, or call 888-227-7669 for information on free tax return preparation.

MilTax. Members of the U.S. Armed Forces and qualified veterans may use MilTax, a free tax service offered by the Department of Defense through Military OneSource. For more information, go to MilitaryOneSource ( MilitaryOneSource.mil/MilTax ).

Also, the IRS offers Free Fillable Forms, which can be completed online and then filed electronically regardless of income.

Go to IRS.gov/Tools for the following.

The Earned Income Tax Credit Assistant ( IRS.gov/EITCAssistant ) determines if you’re eligible for the earned income credit (EIC).

The Online EIN Application ( IRS.gov/EIN ) helps you get an employer identification number (EIN) at no cost.

The Tax Withholding Estimator ( IRS.gov/W4app ) makes it easier for everyone to pay the correct amount of tax during the year. The tool is a convenient, online way to check and tailor your withholding. It’s more user-friendly for taxpayers, including retirees and self-employed individuals. The features include the following.

▶ Easy to understand language.

▶ The ability to switch between screens, correct previous entries, and skip screens that don’t apply.

▶ Tips and links to help you determine if you qualify for tax credits and deductions.

▶ A progress tracker.

▶ A self-employment tax feature.

▶ Automatic calculation of taxable social security benefits.

The First-Time Homebuyer Credit Account Look-up ( IRS.gov/HomeBuyer ) tool provides information on your repayments and account balance.

The Sales Tax Deduction Calculator ( IRS.gov/SalesTax ) figures the amount you can claim if you itemize deductions on Schedule A (Form 1040).

IRS.gov/Help : A variety of tools to help you get answers to some of the most common tax questions.

IRS.gov/ITA : The Interactive Tax Assistant, a tool that will ask you questions and, based on your input, provide answers on a number of tax law topics.

IRS.gov/Forms : Find forms, instructions, and publications. You will find details on 2021 tax changes and hundreds of interactive links to help you find answers to your questions.

You may also be able to access tax law information in your electronic filing software.

There are various types of tax return preparers, including tax preparers, enrolled agents, certified public accountants (CPAs), attorneys, and many others who don’t have professional credentials. If you choose to have someone prepare your tax return, choose that preparer wisely. A paid tax preparer is:

Primarily responsible for the overall substantive accuracy of your return,

Required to sign the return, and

Required to include their preparer tax identification number (PTIN).

Although the tax preparer always signs the return, you're ultimately responsible for providing all the information required for the preparer to accurately prepare your return. Anyone paid to prepare tax returns for others should have a thorough understanding of tax matters. For more information on how to choose a tax preparer, go to Tips for Choosing a Tax Preparer on IRS.gov.

From July through December 2021, advance payments were sent automatically to taxpayers with qualifying children who met certain criteria. The advance child tax credit payments were early payments of up to 50% of the estimated child tax credit that taxpayers may properly claim on their 2021 returns. Go to IRS.gov/AdvCTC for more information about these payments and how they can affect your taxes.

Go to IRS.gov/Coronavirus for links to information on the impact of the coronavirus, as well as tax relief available for individuals and families, small and large businesses, and tax-exempt organizations.

The Social Security Administration (SSA) offers online service at SSA.gov/employer for fast, free, and secure online W-2 filing options to CPAs, accountants, enrolled agents, and individuals who process Form W-2, Wage and Tax Statement, and Form W-2c, Corrected Wage and Tax Statement.

Go to IRS.gov/SocialMedia to see the various social media tools the IRS uses to share the latest information on tax changes, scam alerts, initiatives, products, and services. At the IRS, privacy and security are our highest priority. We use these tools to share public information with you. Don’t post your social security number (SSN) or other confidential information on social media sites. Always protect your identity when using any social networking site.

The following IRS YouTube channels provide short, informative videos on various tax-related topics in English, Spanish, and ASL.

Youtube.com/irsvideos .

Youtube.com/irsvideosmultilingua .

Youtube.com/irsvideosASL .

The IRS Video portal (IRSVideos.gov) contains video and audio presentations for individuals, small businesses, and tax professionals.

You can find information on IRS.gov/MyLanguage if English isn’t your native language.

The IRS is committed to serving our multilingual customers by offering OPI services. The OPI Service is a federally funded program and is available at Taxpayer Assistance Centers (TACs), other IRS offices, and every VITA/TCE return site. The OPI Service is accessible in more than 350 languages.

Taxpayers who need information about accessibility services can call 833-690-0598. The Accessibility Helpline can answer questions related to current and future accessibility products and services available in alternative media formats (for example, braille, large print, audio, etc.).

Go to IRS.gov/Forms to view, download, or print all of the forms, instructions, and publications you may need. Or, you can go to IRS.gov/OrderForms to place an order.

You can also download and view popular tax publications and instructions (including the Instructions for Form 1040) on mobile devices as eBooks at IRS.gov/eBooks .

IRS eBooks have been tested using Apple's iBooks for iPad. Our eBooks haven’t been tested on other dedicated eBook readers, and eBook functionality may not operate as intended.

Go to IRS.gov/Account to securely access information about your federal tax account.

View the amount you owe and a breakdown by tax year.

See payment plan details or apply for a new payment plan.

Make a payment or view 5 years of payment history and any pending or scheduled payments.

Access your tax records, including key data from your most recent tax return, your EIP amounts, and transcripts.

View digital copies of select notices from the IRS.

Approve or reject authorization requests from tax professionals.

View your address on file or manage your communication preferences.

This tool lets your tax professional submit an authorization request to access your individual taxpayer IRS online account . For more information, go to IRS.gov/TaxProAccount .

The fastest way to receive a tax refund is to file electronically and choose direct deposit, which securely and electronically transfers your refund directly into your financial account. Direct deposit also avoids the possibility that your check could be lost, stolen, or returned undeliverable to the IRS. Eight in 10 taxpayers use direct deposit to receive their refunds. If you don’t have a bank account, go to IRS.gov/DirectDeposit for more information on where to find a bank or credit union that can open an account online.

The quickest way to get a copy of your tax transcript is to go to IRS.gov/Transcripts . Click on either “Get Transcript Online” or “Get Transcript by Mail” to order a free copy of your transcript. If you prefer, you can order your transcript by calling 800-908-9946.

Tax-related identity theft happens when someone steals your personal information to commit tax fraud. Your taxes can be affected if your SSN is used to file a fraudulent return or to claim a refund or credit.

The IRS doesn’t initiate contact with taxpayers by email, text messages, telephone calls, or social media channels to request personal or financial information. This includes requests for personal identification numbers (PINs), passwords, or similar information for credit cards, banks, or other financial accounts.

Go to IRS.gov/IdentityTheft , the IRS Identity Theft Central webpage, for information on identity theft and data security protection for taxpayers, tax professionals, and businesses. If your SSN has been lost or stolen or you suspect you’re a victim of tax-related identity theft, you can learn what steps you should take.

Get an Identity Protection PIN (IP PIN). IP PINs are six-digit numbers assigned to taxpayers to help prevent the misuse of their SSNs on fraudulent federal income tax returns. When you have an IP PIN, it prevents someone else from filing a tax return with your SSN. To learn more, go to IRS.gov/IPPIN .

Go to IRS.gov/Refunds .

Download the official IRS2Go app to your mobile device to check your refund status.

Call the automated refund hotline at 800-829-1954.

The IRS can’t issue refunds before mid-February 2022 for returns that claimed the EIC or the additional child tax credit (ACTC). This applies to the entire refund, not just the portion associated with these credits.

Go to IRS.gov/Payments for information on how to make a payment using any of the following options.

IRS Direct Pay : Pay your individual tax bill or estimated tax payment directly from your checking or savings account at no cost to you.

Debit or Credit Card : Choose an approved payment processor to pay online or by phone.

Electronic Funds Withdrawal : Schedule a payment when filing your federal taxes using tax return preparation software or through a tax professional.

Electronic Federal Tax Payment System : Best option for businesses. Enrollment is required.

Check or Money Order : Mail your payment to the address listed on the notice or instructions.

Cash : You may be able to pay your taxes with cash at a participating retail store.

Same-Day Wire : You may be able to do same-day wire from your financial institution. Contact your financial institution for availability, cost, and time frames.

The IRS uses the latest encryption technology to ensure that the electronic payments you make online, by phone, or from a mobile device using the IRS2Go app are safe and secure. Paying electronically is quick, easy, and faster than mailing in a check or money order.

Go to IRS.gov/Payments for more information about your options.

Apply for an online payment agreement ( IRS.gov/OPA ) to meet your tax obligation in monthly installments if you can’t pay your taxes in full today. Once you complete the online process, you will receive immediate notification of whether your agreement has been approved.

Use the Offer in Compromise Pre-Qualifier to see if you can settle your tax debt for less than the full amount you owe. For more information on the Offer in Compromise program, go to IRS.gov/OIC .

You can now file Form 1040-X electronically with tax filing software to amend 2019 or 2020 Forms 1040 and 1040-SR. To do so, you must have e-filed your original 2019 or 2020 return. Amended returns for all prior years must be mailed. Go to IRS.gov/Form1040X for information and updates.

Go to IRS.gov/WMAR to track the status of Form 1040-X amended returns.

It can take up to 3 weeks from the date you filed your amended return for it to show up in our system, and processing it can take up to 16 weeks.

Go to IRS.gov/Notices to find additional information about responding to an IRS notice or letter.

You can use Schedule LEP, Request for Change in Language Preference, to state a preference to receive notices, letters, or other written communications from the IRS in an alternative language, when these are available. Once your Schedule LEP is processed, the IRS will determine your translation needs and provide you translations when available. If you have a disability requiring notices in an accessible format, see Form 9000.

Keep in mind, many questions can be answered on IRS.gov without visiting an IRS TAC. Go to IRS.gov/LetUsHelp for the topics people ask about most. If you still need help, IRS TACs provide tax help when a tax issue can’t be handled online or by phone. All TACs now provide service by appointment, so you’ll know in advance that you can get the service you need without long wait times. Before you visit, go to IRS.gov/TACLocator to find the nearest TAC and to check hours, available services, and appointment options. Or, on the IRS2Go app, under the Stay Connected tab, choose the Contact Us option and click on “Local Offices.”

The Taxpayer Advocate Service (TAS) Is Here To Help You

TAS is an independent organization within the IRS that helps taxpayers and protects taxpayer rights. Their job is to ensure that every taxpayer is treated fairly and that you know and understand your rights under the Taxpayer Bill of Rights .

The Taxpayer Bill of Rights describes 10 basic rights that all taxpayers have when dealing with the IRS. Go to TaxpayerAdvocate.IRS.gov to help you understand what these rights mean to you and how they apply. These are your rights. Know them. Use them.

TAS can help you resolve problems that you can’t resolve with the IRS. And their service is free. If you qualify for their assistance, you will be assigned to one advocate who will work with you throughout the process and will do everything possible to resolve your issue. TAS can help you if:

Your problem is causing financial difficulty for you, your family, or your business;

You face (or your business is facing) an immediate threat of adverse action; or

You’ve tried repeatedly to contact the IRS but no one has responded, or the IRS hasn’t responded by the date promised.

TAS has offices in every state, the District of Columbia, and Puerto Rico . Your local advocate’s number is in your local directory and at TaxpayerAdvocate.IRS.gov/Contact-Us . You can also call them at 877-777-4778.

TAS works to resolve large-scale problems that affect many taxpayers. If you know of one of these broad issues, report it to them at IRS.gov/SAMS .

TAS can provide a variety of information for tax professionals, including tax law updates and guidance, TAS programs, and ways to let TAS know about systemic problems you’ve seen in your practice.

LITCs are independent from the IRS. LITCs represent individuals whose income is below a certain level and need to resolve tax problems with the IRS, such as audits, appeals, and tax collection disputes. In addition, LITCs can provide information about taxpayer rights and responsibilities in different languages for individuals who speak English as a second language. Services are offered for free or a small fee for eligible taxpayers. To find an LITC near you, go to TaxpayerAdvocate.IRS.gov/about-us/Low-Income-Taxpayer-Clinics-LITC or see IRS Pub. 4134, Low Income Taxpayer Clinic List .

Battling Uphill Against the Assignment of Income Doctrine: Ryder

Benjamin Alarie

Kathrin Gardhouse

Benjamin Alarie is the Osler Chair in Business Law at the University of Toronto and the CEO of Blue J Legal Inc. Kathrin Gardhouse is a legal research associate at Blue J Legal .

In this article, Alarie and Gardhouse examine the Tax Court ’s recent decision in Ryder and use machine-learning models to evaluate the strength of the legal factors that determine the outcome of assignment of income cases.

Copyright 2021 Benjamin Alarie and Kathrin Gardhouse . All rights reserved.

I. Introduction

Researching federal income tax issues demands distilling the law from the code, regulations, revenue rulings, administrative guidance, and sometimes hundreds of tax cases that may all be relevant to a particular situation. When a judicial doctrine has been developed over many decades and applied in many different types of cases, the case-based part of this research can be particularly time consuming. Despite an attorney’s best efforts, uncertainty often remains regarding how courts will decide a new set of facts, as previously decided cases are often distinguished and the exercise of judicial discretion can at times lead to surprises. To minimize surprises as well as the time and effort involved in generating tax advice, Blue J ’s machine-learning modules allow tax practitioners to assess the likely outcome of a case if it were to go to court based on the analysis of data from previous decisions using machine learning. Blue J also identifies cases with similar facts, permitting more efficient research.

In previous installments of Blue J Predicts, we examined the strengths and weaknesses of ongoing or recently decided appellate cases, yielding machine-learning-generated insights about the law and predicting the outcomes of cases. In this month’s column, we look at a Tax Court case that our predictor suggests was correctly decided (with more than 95 percent confidence). The Ryder case 1 has received significant attention from the tax community. It involved tax avoidance schemes marketed by the law firm Ernest S. Ryder & Associates Inc. (R&A) that produced more than $31 million in revenue between 2003 and 2011 and for which the firm reported zero taxable income. The IRS unmasked more than 1,000 corporate entities that R&A’s owner, Ernest S. Ryder , had created and into which he funneled the money. By exposing the functions that these entities performed, the IRS played the most difficult role in the case. Yet, there are deeper lessons that can be drawn from the litigation by subjecting it to analysis using machine learning.

In this installment of Blue J Predicts, we shine an algorithmic spotlight on the legal factors that determine the outcomes of assignment of income cases such as Ryder . For Ryder , the time for filing an appeal has elapsed and the matter is settled. Thus, we use it to examine the various factors that courts look to in this area and to show the effect those factors have in assignment of income cases. Equipped with our machine-learning module, we are able to highlight the fine line between legitimate tax planning and illegitimate tax avoidance in the context of the assignment of income doctrine.

II. Background

In its most basic iteration, the assignment of income doctrine stands for the proposition that income is taxed to the individual who earns it, even if the right to that income is assigned to someone else. 2 Courts have held that the income earner is responsible for the income tax in the overwhelming majority of cases, including Ryder . It is only in a small number of cases that courts have been willing to accept the legitimacy of an assignment and have held that the assignee is liable for the earned income. Indeed, Blue J ’s “Assigned Income From Services” predictor, which draws on a total of 242 cases and IRS rulings, includes only 10 decisions in which the assignee has been found to be liable to pay tax on the income at issue.

The wide applicability of the assignment of income doctrine was demonstrated in Ryder , in which the court applied the doctrine to several different transactions that occurred between 1996 and 2011. Ryder founded his professional law corporation R&A in 1996 and used his accounting background, law degree, and graduate degree in taxation for the benefit of his clients. R&A designed, marketed, sold, and administered six aggressive tax-saving products that promised clients the ability to “defer a much greater portion of their income than they ever dreamed possible, and, as a result, substantially reduce their tax liability.” 3 In 2003 the IRS caught on to Ryder ’s activities when his application to have 800 employee stock option plans qualified at the same time was flagged for review. A decade of investigations and audits of Ryder and his law firm spanning from 2002 to 2011 followed.

What is interesting in this case is that Ryder , through his law firm R&A, directly contracted with his clients for only three of the six tax-saving products that his firm designed, marketed, and sold (the stand-alone products). The fees collected by R&A from two of the stand-alone products were then assigned to two other entities through two quite distinct mechanisms. For the other three tax-saving products, the clients contracted — at least on paper — with other entities that Ryder created (the group-tax products). Yet, the court treated the income from all six tax-saving products identically. The differences between the six types of transactions did not affect the outcome of the case — namely, that it is R&A’s income in all six instances. Blue J ’s predictor can explain why: The factors that our predictor highlights as relevant for answering the question whether the assignment of income doctrine applies have less to do with the particular strategy that the income earner conjures up for making it look like the income belongs to someone else, and more to do with different ways of pinpointing who actually controls the products, services, and funds. In Ryder , the choices ultimately come down to whether that is R&A or the other entity.

We will begin the analysis of the case by taking a closer look at two of the six tax-saving products, paying particular attention to the flow of income from R&A’s clients to R&A and Ryder ’s assignment of income to the other entities. We have selected one of the tax-saving products in which Ryder drew up an explicit assignment agreement, and another one in which he tried to make it look like the income was directly earned by another entity he had set up. Regardless of the structures and means employed, the court, based on the IRS ’s evidence, traced this income to R&A and applied the assignment of income doctrine to treat it as R&A’s income.

This article will not cover in detail the parts of the decision in which the court reconstructs the many transactions Ryder and his wife engaged in to purchase various ranches using the income that had found its way to R& A. As the court puts it, the complexity of the revenues and flow of funds is “baroque” when R&A is concerned, and when it comes to the ranches, it becomes “ rococo .” 4 We will also not cover the fraud and penalty determinations that the court made in this case.

III. The Tax Avoidance Schemes

We will analyze two of the six schemes discussed in the case. The first is the staffing product, and the second is the American Specialty Insurance Group Ltd. (ASIG) product. Each serves as an example of different mechanisms Ryder employed to divert income tax liability away from R&A. In the case of the staffing product, Ryder assigned income explicitly to another entity. The ASIG product involved setting up another entity that Ryder argued earned the income directly itself.

A. The Staffing Product

R&A offered a product to its clients in the course of which the client could lease its services to a staffing corporation, which would in turn lease the client’s services back to the client’s operating business. The intended tax benefit lay “with the difference between the lease payment and the wages received becoming a form of compensation that was supposedly immune from current taxation.” 5 At first, the fees from the staffing product were invoiced by and paid to R&A. When the IRS started its investigation, Ryder drew up an “Agreement of Assignment and Assumption” with the intent to assign all the clients and the income from the staffing product to ESOP Legal Consultants Inc. ( ELC ). Despite the contractual terms limiting the agreement to the 2004-2006 tax years, Ryder used ELC ’s bank account until 2011 to receive fees paid by the various S corporations he had set up for his clients to make the staffing product work. R&A would then move the money from this bank account into Ryder ’s pocket in one way or another. ELC had no office space, and the only evidence of employees was six names on the letterhead of ELC indicating their positions. When testifying in front of the court, two of these employees failed to mention that they were employed by ELC , and one of them was unable to describe the work ELC was allegedly performing. Hence, the court concluded that ELC did not have any true employees of its own and did not conduct any business. Instead, it was R&A’s employees that provided any required services to the clients. 6

B. The ASIG Product

R&A sold “disability and professional liability income insurance” policies to its clients using ASIG, a Turks and Caicos corporation that was a captive insurer owned by Capital Mexicana . Ryder had created these two companies during his previous job with the help of the Turks and Caicos accounting firm Morris Cottingham Ltd. The policies Ryder sold to his clients required them to pay premiums to ASIG as consideration for the insurance. The premiums were physically mailed to R& A. Also , the clients were required to pay a 2 percent annual fee, which was deposited into ASIG’s bank account. In return, the clients received 98 percent of the policy’s cash value in the event that they became disabled, separated from employment, turned 60, or terminated the policy. 7

R&A’s involvement in these deals, aside from setting up ASIG, was to find the clients who bought the policies, assign them a policy number, draft a policy, and open a bank account for the client, as well as provide legal services for the deal as needed. It was R&A that billed the client and that ensured, with Morris Cottingham ’s help, that the fees were paid. R&A employees would record the ASIG policy fee paid by the clients, noting at times that “pymt bypassed [R&A’s] books.” 8 Quite an effort went into disguising R&A’s involvement.

First, there was no mention of R&A on the policy itself. Second, ASIG’s office was located at Morris Cottingham’s Turks and Caicos corporate services. Ryder also set up a post office box for ASIG in Las Vegas. Any mail sent to it was forwarded to Ryder . Third, to collect the fees, R&A would send a letter to Morris Cottingham for signature, receive the signed letter back, and then fax it to the financial institution where ASIG had two accounts. One of these was nominally in ASIG’s name but really for the client’s benefit, and the other account was in Ryder ’s name. The financial institution would then move the amount owed in fees from the former to the latter account. Whenever a client filed for a benefit under the policy, the client would prepare a claim package and pay a termination fee that also went into the ASIG account held in Ryder ’s name. The exchanges between the clients and ASIG indicate that these fees were to reimburse ASIG for its costs and services, as well as to allow it to derive a profit therefrom. But the court found that ASIG itself did nothing. Even the invoices sent to clients detailing these fee payments that were on ASIG letterhead were in fact prepared by R&A. In addition to the annual fees and the termination fee, clients paid legal fees on a biannual basis for services Ryder provided. These legal fees, too, were paid into the ASIG account in Ryder ’s name. 9

IV. Assignment of Income Doctrine

The assignment of income doctrine attributes income tax to the individual who earns the income, even if the right to that income is assigned to another entity. The policy rationale underlying the doctrine is to prevent high-income taxpayers from shifting their taxable income to others. 10 The doctrine is judicial and was first developed in 1930 by the Supreme Court in Lucas , a decision that involved contractual assignment of personal services income between a husband and wife. 11 The doctrine expanded significantly over the next 20 years and beyond, and it has been applied in many different types of cases involving gratuitous transfers of income or property. 12 The staffing product, as of January 2004, involved an anticipatory assignment of income to which the assignment of services income doctrine had been held to apply in Banks . 13 The doctrine is not limited to situations in which the income earner explicitly assigns the income to another entity; it also captures situations in which the actual income earner sets up another entity and makes it seem as if that entity had earned the income itself, as was the case with the ASIG product. 14

In cases in which the true income earner is in question, the courts have held that “the taxable party is the person or entity who directed and controlled the earning of the income, rather than the person or entity who received the income.” 15 Factors that the courts consider to determine who is in control of the income depend on the particular situation at issue in the case. For example, when a personal services business is involved, the court looks at the relationship between the hirer and the worker and who has the right to direct the worker’s activities. In partnership cases, the courts apply the similarity test, asking whether the services the partnership provided are similar to those the partner provided. In other cases, the courts have inquired whether an agency relationship can be established. In yet other cases the courts have taken a broad and flexible approach and consulted all the available evidence to determine who has the ultimate direction and control over the earnings. 16

V. Factors Considered in Ryder

Judge Mark V. Holmes took a flexible approach in Ryder . He found that none of the entities that Ryder papered into existence had their own office or their own employees. They were thus unable to provide the services Ryder claims they were paid for. In fact, the entities did not provide any services at all — the services were R&A’s doing. To top it off, R&A did nothing but set up the entities, market their tax benefits, and move money around once the clients signed up for the products. There was no actual business activity conducted. The court further found that the written agreements the clients entered into with the entities that purported to provide services to them were a sham and that oral contracts with R&A were in fact what established the relevant relationship, so that R&A must be considered the contracting party. In the case of the ASIG product, for example, a client testified that the fees he paid to Ryder were part of his retirement plan. Ryder had represented to him that the ASIG product was established to create an alternative way to accumulate retirement savings. 17

Regarding the staffing product in which there existed an explicit assignment of income agreement between R&A and ELC , the court found that ELC only existed on paper and in the form of bank accounts, with the effect that R&A was ultimately controlling the income even after the assignment. A further factor that the court emphasized repeatedly was that R&A, and Ryder personally as R&A’s owner, kept benefitting from the income after the assignment (for example, in the staffing product case) or, as in the case of the ASIG product, despite the income allegedly having been earned by a third party (that is, ASIG). 18

VI. Analysis

The aforementioned factors are reflected in Blue J ’s Assigned Income From Services predictor. 19 We performed predictions for the following scenarios:

the staffing product and R&A’s assignment of the income it generated to ELC with the facts as found by the court;

the staffing product and R&A’s assignment of the income it generated to ELC if Ryder ’s version of the facts were accepted;

the ASIG product and service as the court interpreted and characterized the facts; and

the ASIG product and service according to Ryder ’s narrative.

What is interesting and indicative of the benefits that machine-learning tools such as Blue J ’s predictor can provide to tax practitioners is that even if the court had found in Ryder ’s favor on all the factual issues reasonably in dispute, Ryder would still not have been able to shift the tax liability to ELC or ASIG respectively, according to our model and analysis.

The court found that R&A contracted directly with, invoiced, and received payments from its clients regarding the staffing product up until 2004, when Ryder assigned the income generated from this product explicitly to ELC . From then onward, ELC received the payments from the clients instead of R&A. Further, the court found that ELC did not have its own employees or office space and did not conduct any business activity. Our data show that the change in the recipient of the money would have made no difference regarding the likelihood of R&A’s liability for the income tax in this scenario.

According to Ryder ’s version of the facts, ELC did have its own employees, 20 even though there is no mention of a separate office space from which ELC allegedly operated. Yet, Ryder maintains that ELC was the one providing the staffing services to its clients after the assignment of the clients to the company in January 2004. Even if Ryder had been able to convince the court of his version of the facts, it would hardly have made a dent in the likelihood of the outcome that R&A would be held liable for the tax payable on the income from the staffing product.

With Ryder ’s narrative as the underlying facts, our predictor is still 94 percent confident that R&A would have been held liable for the tax. The taxation of the income in the hands of the one who earned it is not easily avoided with a simple assignment agreement, particularly if the income earner keeps benefiting from the income after the assignment and continues to provide services himself without giving up control over the services for the benefit of the assignee. The insight gained from the decision regarding the staffing product is that the court will take a careful look behind the assignment agreement and, if it is not able to spot a legitimate assignee, the assignment agreement will be disregarded.

The court made the same factual findings regarding the ASIG product as it did for the staffing product post-assignment. Ryder , however, had more to say here in support of his case. For one, he pointed to ASIG’s main office that was located at the Morris Cottingham offices. Morris Cottingham was also the one that, on paper, contracted with clients for the insurance services and the collection of fees was conducted, again on paper, in the name of Morris Cottingham . The court also refers to actual claims that the clients made under their policies. There is also a paper trail that indicates that the clients were explicitly acknowledging and in fact paying ASIG for its costs and services. From all this we can conclude that Ryder was able to argue that ASIG had its own independent office, had one or more employees providing services, and that ASIG engaged in actual business activity. However, even if these facts had been admitted as accurately reflecting the ASIG product, our data show that with a 92 percent certainty R&A would still be liable for the income tax payable on the income the ASIG product generated. It is clear that winning a case involving the assignment of income doctrine on facts such as the ones in Ryder is an uphill battle. If the person behind the scenes remains involved with the services provided without giving up control over them, and benefits from the income generated, it is a lost cause to argue that the assignment of income doctrine should be applied with the effect that the entity that provides the services on paper is liable for the income tax.

C. Ryder as ASIG’s Agent

Our data reveal that to have a more substantial shot at succeeding with his case under the assignment of income doctrine, Ryder would have had to pursue a different line of argument altogether. Had he set R&A up as ASIG’s agent rather than tried to disguise its involvement with the purported insurance business, Ryder would have been more likely to succeed in shifting the income tax liability to ASIG. For our analysis of the effect of the different factors discussed by the court in Ryder , we assume at the outset that Ryder would do everything right — that is, ASIG would have its own workers and office, and it would do something other than just moving money around (best-case scenario). We then modify each factor one by one to reveal their respective effect.

From this scenario testing, we can conclude that if R&A had had an agency agreement with ASIG, received some form of compensation for its services from ASIG, held itself out to act on ASIG’s behalf, and the client was interested in R&A’s service because of its affiliation with ASIG, Ryder would have reduced the likelihood to 73 percent of R&A being liable for the income tax. Add to these agency factors an element of monitoring by ASIG and the most likely result flips — there would be a 64 percent likelihood that ASIG would be liable for the income tax. If ASIG were to go beyond monitoring R&A’s services by controlling them too, the likelihood that ASIG would be liable for the income tax would increase to 82 percent. Let’s say Ryder had given Morris Cottingham oversight and control over R&A’s services for ASIG, then the question whether ASIG employs any workers other than R&A arguably becomes moot because there would necessarily be an ASIG employee who oversees R&A. Accordingly, there is hardly any change in the confidence level of the prediction that ASIG is liable for the income tax when the worker factor is absent.

Interestingly, this is quite different from the effect of the office factor. Keeping everything else as-is, the absence of having its own ASIG-controlled office decreases the likelihood of ASIG being liable to pay the income tax from 82 to 54 percent. Note here that our Assigned Income From Services predictor is trained on data from relatively old cases; only 14 are from the last decade. This may explain why the existence of a physical office space is predicted to play such an important role when the courts determine whether the entity that allegedly earns the income is a legitimate business. In a post-pandemic world, it may be possible that a trend will emerge that puts less emphasis on the physical office space when determining the legitimacy of a business.

The factor that stands out as the most important one in our hypothetical scenario in which R&A is the agent of ASIG is the characterization of ASIG’s own business activity. In the absence of ASIG conducting its own business, nothing can save Ryder ’s case. This makes intuitive sense because if ASIG conducts no business, it must be R&A’s services alone that generate the income; hence R&A is liable for the tax on the income. Also very important is the contracting party factor: If the client were to contract with R&A rather than ASIG in our hypothetical scenario, the likelihood that R&A would be held liable for the income tax is back up to 72 percent, all else being equal. If the client were to contract with both R&A and ASIG, it is a close case, leaning towards ASIG’s liability with 58 percent confidence. Much less significant is who receives the payment between the two. If it is R&A, ASIG remains liable for the income tax with a likelihood of 71 percent, indicating a drop in confidence by 11 percent compared with a scenario in which ASIG received the payment.

To summarize, if Ryder had pursued a line of argument in which he set up R&A as ASIG’s agent, giving ASIG’s employee(s) monitoring power and ideally control over R&A’s services for ASIG, he would have had a better chance of succeeding under the assignment of income doctrine. As we have seen, the main prerequisite for his success would have been to convince the court that it would be appropriate to characterize ASIG as conducting business. Ideally, Ryder also would have made sure that the client contracted for the services with ASIG and not with R&A. However, it is significantly less important that ASIG receives the money from the client. The historical case law also suggests that Ryder would have been well advised to set up a physical office for ASIG; however, given the new reality of working from home, this factor may no longer be as relevant as these older previously decided cases indicate.

VII. Conclusion

We have seen that R&A’s chances to shift the liability for the tax payable on the staffing and the ASIG product income was virtually nonexistent. The difficulty of this case from the perspective of the IRS certainly lay in gathering the evidence, tracing the money through the winding paths of Ryder ’s paper labyrinth, and making it comprehensible for the court. Once this had been accomplished, the IRS had a more-or-less slam-dunk case regarding the applicability of the assignment of income doctrine. As mentioned at the outset, an assignment of income case will always be an uphill battle for the taxpayer because income is generally taxable to whoever earns it.

Yet, in cases in which the disputed question is who earned the income and not whether the assignment agreement has shifted the income tax liability, the parties must lean into the factors discussed here to convince the court of the legitimacy (or the illegitimacy, in the case of the government) of the ostensibly income-earning entity and its business. Our analysis can help decide which of the factors must be present to have a plausible argument, which ones are nice to have, and which should be given little attention in determining an efficient litigation strategy.

1   Ernest S. Ryder & Associates Inc. v. Commissioner , T.C. Memo. 2021-88 .

2   Lucas v. Earl , 281 U.S. 111, 114-115 (1930).

3   Ryder , T.C. Memo. 2021-88, at 7.

4   Id. at 32.

5   Id. at 17, 19, and 111-112.

6   Id. at 51-52, 111-112, and 123-126.

7   Id. at 9-12.

8   Id. at 96.

10  CCH, Federal Taxation Comprehensive Topics, at 4201.

11   Lucas , 281 U.S. at 115.

12   See , e.g. , “familial partnership” cases — Burnet v. Leininger , 285 U.S. 136 (1932); Commissioner v. Tower , 327 U.S. 280 (1946); and Commissioner v. Culbertson , 337 U.S. 733 (1949). For an application in the commercial context, see Commissioner v. Banks , 543 U.S. 426 (2005).

13   Banks , 543 U.S. at 426.

14   See , e.g. , Johnston v. Commissioner , T.C. Memo. 2000-315 , at 487.

16   Ray v. Commissioner , T.C. Memo. 2018-160 .

17   Ryder , T.C. Memo. 2021-88, at 90-91.

18   Id. at 48, 51, and 52.

19  The predictor considered several further factors that play a greater role in other fact patterns.

20  The court mentions that ELC’s letterhead set out six employees and their respective positions with the company.

END FOOTNOTES

This site uses cookies to store information on your computer. Some are essential to make our site work; others help us improve the user experience. By using the site, you consent to the placement of these cookies. Read our  privacy policy  to learn more.

• GAINS & LOSSES

Taxing the Transfer of Debts Between Debtors and Creditors

• C Corporation Income Taxation
• NOL & Other Tax Attributes
• Individual Income Taxation

T he frequent transfer of cash between closely held businesses and their owners is very common. If the owner works in the business, the transfer is likely to be either a salary to a shareholder/employee or a Sec. 707(c) guaranteed payment to a partner. Alternatively, the transfer may be a loan. As long as the true substance of the transaction is a loan, it will be respected for tax purposes. 1

The cash flow is not exclusively from the businesses to the owner. Many owners prefer to capitalize their closely held business with a combination of equity and debt. Once again, these loans will be respected and not reclassified as equity if they are bona fide loans.

In the normal course of business, these loans are repaid. The receipt of the repayment will be tax free except to the extent it is interest. However, in difficult economic conditions, many of these loans are not repaid. To the extent that the creditor cancels the obligation, the debtor has cancellation of debt (COD) income under Sec. 61(a)(12). This income is taxable unless the taxpayer qualifies for an exclusion under Sec. 108. In other cases, the debt is transferred between the parties either as an independent transaction or part of a larger one. This article reviews these transactions.

Two basic types of transfers have created significant tax issues. In the first, the debtor transfers the debt to the creditor. If the debtor is the owner of a business and the business is a creditor, the transfer appears to be a contribution. If the business is the debtor and the owner is the creditor, the transfer can be a distribution, liquidation, or reorganization. The other type of transfer is from the creditor to the debtor. Again, the transaction can take the form of a contribution if the creditor is the owner, or it can take the form of a distribution, liquidation, or reorganization if the creditor is the business.

Debtor-to-Creditor Transfers

Corporations.

The two seminal cases that established the framework for analyzing the transfer of a debt obligation from a debtor to a creditor are Kniffen 2 and Edwards Motor Transit Co. 3 Arthur Kniffen ran a sole proprietorship and owned a corporation. The sole proprietorship borrowed money from the corporation. For valid business reasons, Kniffen transferred the assets and liabili ties of the proprietorship to the corporation in exchange for stock of the corporation, thereby transferring a debt from the debtor to the creditor. The transaction met the requirements of Sec. 351.

The government argued that the transfer of the debt to the creditor was in fact a discharge or cancellation of the debt (a single step), which should have been treated as the receipt of boot under Sec. 351(b) and taxed currently. The taxpayer argued that the transfer was an assumption of the debt and, based on Sec. 357(a), should not be treated as boot.

The Tax Court acknowledged that the debt was canceled by operation of law. However, it did not accept the government’s argument as to the structure of the transaction. Instead, it determined that two separate steps occurred. First, the corporation assumed the debt. This assumption was covered by Sec. 357(a). After the assumption, the interests of the debtor and creditor merged and the debt was extinguished. Since the transfer was not for tax avoidance purposes, Sec. 357(b) did not apply. The result was a tax-free Sec. 351 transaction, except to the extent that the assumed debt exceeded the bases of the assets transferred, resulting in gain under Sec. 357(c). This decision established the separation of the debt transfer from its extinguishment.

Edwards Motor Transit Co. cites, and is considered to have adopted, the approach in Kniffen . For valid business reasons, the owners of Edwards created The Susquehanna Co., a holding company, and transferred Edwards’ stock to it under Sec. 351. Susquehanna borrowed money from Edwards to meet certain financial obligations. To eliminate problems that arose from having a holding company owning the stock of an operating company, the owners merged Susquehanna into Edwards under Sec. 368(a)(1)(A). The government acknowledged that the basic transaction was a nontaxable merger. However, the government wanted the company to recognize income as a result of the cancellation or forgiveness of the debt. The Tax Court ruled for the taxpayer, on the grounds that the debt transfer (from debtor to creditor) was not a cancellation of the debt. The ruling cited Kniffen as authority for this conclusion.

On its surface, Edwards Motor Transit affirmed the decision and reasoning in Kniffen . The Tax Court stated, “The transfer by the parent corporation of its assets to Edwards [its subsidiary] . . . constituted payment of the outstanding liabilities . . . just as surely as if Susquehanna had made payment in cash.” This statement relied on both Kniffen and Estate of Gilmore. 4 In Gilmore , a liquidating corporation transferred a receivable to its shareholder who happened to be the debtor. In that case, the court ruled the transaction was an asset transfer and not a forgiveness of debt. The court based its conclusion in large part on the fact that no actual cancellation of the debt occurred.

The statement in Edwards Motor Transit quoted above, however, is inapposite to the conclusion in Kniffen . A payment is not a transfer and assumption of a liability. Since Susquehanna was deemed to have used assets to repay the debt, the Tax Court should have required Susquehanna to recognize gain to the extent that the value of the assets used to repay the debt exceeded their bases. The conclusions in Kniffen and Edwards are consistent only in their holdings that these debt transfers were not cancellations of debts that would result in COD income. In Kniffen, the court ruled that the debt was assumed and then extinguished. In Edwards, the court ruled that the extinguishment of the debt constituted repayment.

It is possible that the Tax Court reached the correct outcome in Edwards Motor Transit but for the wrong reason. In Rev. Rul 72-464, 5 a debtor corporation merged into the creditor corporation in a tax-free A reorganization under Sec. 368(a)(1)(A). The ruling concluded that the debtor corporation did not recognize any gain or loss on the extinguishment of the debt within the acquiring corporation. General Counsel Memorandum (GCM) 34902 6 provided the detailed analysis behind the conclusion.

The GCM cited both Kniffen and Edwards 7 and adopted their underlying rationale. Specifically, it concluded that the basic transaction (the reorganization) results in a transfer of the debt to the acquiring corporation. It is after the transfer that the debt is extinguished by the statutory merger of interests. The transfer is an assumption of debt, which is nontaxable under Sec. 357(a). Therefore, the transferor (debtor corporation) recognizes no gain or loss.

This is exactly what happened in Ed wards . The debt was assumed, not repaid. Therefore, the Tax Court should have reached the conclusion that the transaction was nontaxable under Sec. 357(a) and not have relied on the questionable authority of Estate of Gilmore 8 or concluded that the debt was repaid.

Liquidations

The transactions discussed up to this point have been either tax-free corporate formations (Sec. 351) or tax-free reorganizations (Sec. 361). In a different transaction that is likely to occur, the creditor/shareholder liquidates the debtor corporation.

If the transaction is not between a parent and its subsidiary, taxability is determined by Secs. 331 and 336. Prior to 1986, the outcome might have been determined by Kniffen and Edwards . With the repeal that year of the General Utilities 9 doctrine (tax-free corporate property distributions) and the enactment of current Sec. 336, the outcome is straightforward. Under Sec. 336, the debtor corporation that is liquidated recognizes its gains and losses. Whether the liquidated corporation is treated as using assets to satisfy a debt requiring the recognition of gain or is treated as distributing assets in a taxable transaction under Sec. 336, all the gains and losses are recognized.

The taxation of the shareholder is a little more complex. First, the shareholder must determine how much it received in exchange for the stock. The most reasonable answer is that the shareholder received the value of the assets minus any debt assumed and minus the face amount of the debt owed to it by the liquidated corporation. This amount is used to determine the gain or loss that results from the hypothetical sale of stock under Sec. 331. Second, the shareholder must determine what was received for the debt, whether assets or the debt itself. The amount received in payment of the liquidated corporation’s debt is a nontaxable return of capital. If the shareholder is deemed to have received the debt itself, then the debt is merged out of existence. The basis of all the assets received should be their fair market value (FMV) under either Sec. 334(a) or general basis rules.

If the liquidated corporation is a subsidiary of the creditor/shareholder, the results change. Under Sec. 337, a subsidiary recognizes neither gain nor loss on the transfer of its assets in liquidation to an 80% distributee (parent). Sec. 337(b) expands this rule to include distributions in payment of debts owed to the parent corporation. Therefore, the subsidiary/debtor does not recognize any gain or loss.

The parent corporation (creditor) recognizes no gain or loss on the liquidation of its subsidiary under Sec. 332. The basis of the transferred property in the hands of the parent is carryover basis. 10 This carry­over basis rule also applies to property received as payment of debt if the subsidiary does not recognize gain or loss on the repayment. 11 In other words, the gain or loss is postponed until the assets are disposed of by the parent corporation.

One important exception to the nonrecognition rule is applied to the parent corporation. Under Regs. Sec. 1.332-7, if the parent’s basis in the debt is different from the face amount of the debt, the parent recognizes the realized gain or loss (face amount minus basis) that results from the repayment. Since this regulation does not mention any exception to the rules of Sec. 334(b)(1), the parent corporation is required to use carryover basis for all the assets received without adjustment for any gain or loss recognized on the debt.

This discussion of liquidations assumes that the liquidated corporation is solvent. If it is insolvent, the answer changes. The transaction cannot qualify under Secs. 332 and 337. The shareholder is not treated as receiving any property in exchange for stock; therefore, a loss is allowed under Sec. 165(g). The taxation of the debt depends on the amount, if any, received by the shareholder as a result of the debt.

Partnerships

The taxation of debt transfers involving partnerships is determined, in large part, by Secs. 731, 752, and 707(a)(2)(B). Specifically, the taxation of transfers by debtor partners to the creditor/partnership is determined by the disguised sale rules of Sec. 707(a)(2)(B), whereas transfers by debtor partnerships to a creditor/partner fall under Secs. 731 and 752.

Sec. 707(a)(2)(B) provides that a transfer of property by a partner to a partnership and a related transfer of cash or property to the partner is treated as a sale of property. The regulations specify the extent to which the partnership’s assumption of liabilities from the partner is treated as the distribution of the sale price.

Regs. Sec. 1.707-5 divides assumed liabilities into either qualified liabilities or unqualified liabilities. A qualified liability 12 is one that:

• Was incurred more than two years before the assumption;
• Was incurred within two years of the assumption, but was not incurred in anticipation of the assumption;
• Was allocated to a capital expenditure related to the property transferred to the partnership under Temp. Regs. Sec. 1.163-8T; or
• Was incurred in the ordinary course of business in which it was used, but only if all the material assets of that trade or business are transferred to the partnership.

The amount of qualified recourse liabilities is limited to the FMV of the transferred property reduced by senior liabilities. Any additional recourse liabilities are treated as nonqualified debt.

If a transfer of property is not otherwise treated as part of a sale, the partnership’s assumption of a qualified liability in connection with a transfer of property is not treated as part of a sale. The assumption of nonqualified liabilities is treated as sale proceeds to the extent that the assumed liability exceeds the transferring partner’s share of that liability (as determined under Sec. 752) immediately after the partnership assumes the liability. If no money or other consideration is transferred to the partner by the partnership in the transaction, the assumption of qualified liabilities in a transaction treated as a sale is also treated as sales proceeds to the extent of the transferring partner’s share of that liability immediately after the partnership assumes the liability. 13 Following the assumption of the liability, the interests of the debtor and creditor merge, thereby extinguishing the debt. The result is that generally the full amount of these assumed liabilities are part of the sale proceeds. 14

The assumed liabilities that are not treated as sale proceeds still fall under Sec. 752. Since the transaction results in a reduction of the transferor’s personal liabilities, the taxpayer is deemed to have received a cash distribution equal to the amount of the debt assumed under Sec. 752(b). Given that the debt is immediately extinguished, no amount is allocated to any partner. The end result is that the transferor must recognize gain if the liability transferred exceeds the transferor’s outside basis before the transaction, increased by the basis of any asset transferred to the partnership as part of the transaction.

A partnership may have borrowed money from a partner and then engaged in a transaction that transfers the debt to the creditor/partner. The first question is whether the initial transaction is a loan or capital contribution. Sec. 707(a) permits loans by partners to partnerships. The evaluation of the transaction is similar to one to determine whether a shareholder has loaned money to a corporation or made a capital contribution. The factors laid out in Sec. 385 and Notice 94-47 15 should be considered in this analysis.

Assuming the debt is real and it alone is transferred to the creditor/partner, the outcome is straightforward. The partner is treated as having made a cash contribution to the partnership under Sec. 752(a) to the extent that the amount of debt exceeds the amount allocated to the partner under the Sec. 752 regulations. If part of the debt is allocated to other partners, these other partners are treated as receiving a deemed cash distribution.

If the transfer is part of a larger transaction, then the analysis is a little more complex. The transfer of the other assets is governed by Secs. 737, 731, and 751. Sec. 737 requires a partner to recognize gain if, during the prior seven years, the partner had contributed property with built-in gain to the partnership and the current FMV of the distributed property exceeds the partner’s outside basis. The partner is treated as recognizing gain in an amount equal to the lesser of (1) the excess (if any) of the FMV of property (other than money) received in the distribution over the adjusted basis of such partner’s interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or (2) the net precontribution gain of the partner. The outside basis is increased by the amount of the deemed contribution because the partner assumed a partnership liability. After any gain under Sec. 737 is determined, the general distribution rules of Secs. 731 and 751(b) apply to the transaction. In effect, the transfer to a creditor/partner of a partnership debt owed to the partner is treated the same as any liability assumed by the partner. The extinguishment of the debt should not result in additional tax consequences.

Creditor-to-Debtor Transfers

In addition to debtor-to-creditor transfers, there are creditor-to-debtor transfers. The outcome of these transactions is determined by the two-step analysis in Kniffen . The creditor is treated as having transferred an asset to the debtor/owner. After the transfer, the interests of the debtor and creditor merge, resulting in the extinguishment of the debt. This extinguishment is generally nontaxable since the basis of the debt and the face amount are equal. 16 The result changes if the basis in the hands of the creditor and the adjusted issue price of the debtor are not equal. 17

One of the initial pieces of guidance that addressed this question was Rev. Rul. 72-464. 18 In this ruling, the debt was transferred in a nontaxable transaction. Consequently, the recipient (the debtor) had a carryover basis in the debt. Since this basis was less than the face amount, gain equal to the difference was recognized. This ruling did not explain the reasoning behind the gain recognition or the potential impact if the value of the debt was different from its basis. 19 These items were addressed in Rev. Rul. 93-7. 20

Rev. Rul. 93-7 analyzed a transaction between a partnership and a partner, here designated P and A , respectively. A was a 50% partner. This percentage allowed A to not be a related party to P under Sec. 707(b). P also had no Sec. 751 assets, and A had no share of P ’s liabilities under Sec. 752. These were excluded because they did not affect the reasoning behind the taxation of debt transfers. A issued a debt with a face amount of $100 for $100. P acquired the debt for $100. When the debt was worth $90, it was distributed to A in complete redemption of its interest, which had an FMV of $90 and outside basis of $25. In other words, a creditor/partnership distributed debt to the debtor/partner.

The debt was an asset, a receivable, in the hands of P . When it was distributed to A , P determined its taxation under Sec. 731(b), which provides that no gain or loss is recognized by a partnership on the distribution of property. The application of Sec. 731(b) in this transaction followed directly from Kniffen , which treated the transfer of a debt as a separate transaction from any extinguishment that follows the transfer. Under Sec. 732, A ’s basis in the transferred debt was $25. 21

The basis rules of Sec. 732 assume that a built-in gain or loss on distributed property is realized and recognized when the recipient disposes of the property. In this situation, the distributed debt was extinguished, and therefore no future event would generate taxable gain or loss. Consequently, this extinguishment became a taxable event. In this specific case, A recognized gain of $65 ($90 FMV – $25 basis) and COD income of $10 ($100 face − $90 FMV.) The ruling did not spell out the reasoning for the recognition of both gain and COD income. It is the correct outcome based on Regs. Sec. 1.1001-2. Under that regulation, when property is used to satisfy a recourse obligation, the debtor has gain equal to the difference between the value of the property and its basis, and COD income equal to the difference between the amount of debt and the value of the property used as settlement. The distributed debt is property at the time of the distribution, and the rules of Regs. Sec. 1.1001-2 should apply.

In Rev. Rul. 93-7, the value of the debt was less than the face amount. A debt’s value could exceed its face amount. In that case, the revenue ruling indicated, a deduction for the excess value may be available to the partner as a result of the deemed merger. In Letter Ruling 201105016, 22 the IRS ruled that a taxpayer was entitled to a deduction when it reacquired its debt at a premium as part of a restructuring plan. Rev. Rul. 93-7 cited Regs. Sec. 1.163-4(c)(1), and Letter Ruling 201105016 cited Regs. Sec. 1.163-7(c). Both regulations state that the reacquisition of debt at a premium results in deductible interest expense equal to the repurchase amount minus the adjusted issue price. Regs. Sec. 1.163-4(c)(1) applies to corporate taxpayers, while Regs. Sec. 1.163-7(c) expanded this treatment to all taxpayers. Based on these regulations and the treatment of the distribution as an acquisition of a debt, an interest expense deduction should be permitted when the value exceeds the amount of debt, whereas COD income is recognized when the value is less than the amount of the debt.

In Rev. Rul. 93-7, the partnership was the creditor, and the debt was transferred to a debtor/partner. The reverse transaction can occur, in which a creditor/partner transfers debt to the debtor/partnership in exchange for a capital or profits interest. Sec. 721 applies to the creditor/partner. Therefore, no gain or loss is recognized. However, Sec. 108(e)(8)(B) applies to the debtor/partnership. Sec. 108(e)(8)(B) provides that the partnership recognizes COD income equal to the excess of the debt canceled over the value of the interest received by the creditor. This income is allocated to the partners that owned interests immediately before the transfer. The partnership does not recognize gain or loss (other than the COD income) as a result of this transaction. 23 The value of the interest generally is determined by the liquidation value of the interest received. 24 If the creditor receives a profits interest, the liquidation value is zero, and therefore the partnership recognizes COD income equal to the amount of debt transferred.

Corporate Transactions

Debt transfers between corporations and shareholders are just as likely as transfers between partners and partnerships. If the transferor is a shareholder or becomes a shareholder as a result of the transaction, Secs. 1032, 118, and 351 provide basic nontaxability. However, Sec. 108 overrules these sections in certain cases.

If the shareholder transfers the debt to the corporation as a contribution to capital, Sec. 108(e)(6) may result in the recognition of COD income by the corporation. Under Sec. 108(e)(6), the corporation is treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness. Therefore, the corporation has COD income amount equal to the excess of the face amount of the debt over the transferor’s basis in the debt immediately prior to the transfer. In most cases, the face and basis are equal, and no COD income is recognized. If the transfer is in exchange for stock, Sec. 108(e)(8)(A) provides that the corporation is treated as having satisfied the indebtedness with an amount of money equal to the FMV of the stock. Therefore, the corporation recognizes COD income equal to the excess of the face value of the debt over the value of the stock received. In many cases, the value of the stock is less than the debt canceled, and therefore COD income is recognized. Sec. 351 provides that 80% creditor/shareholders recognize neither gain nor loss if the debt is evidenced by a security. If Sec. 351 does not apply, the creditor/shareholder may be able to claim a loss or bad-debt deduction.

Rev. Rul. 2004-79 25 provides a detailed analysis of the transfer of debt from a creditor corporation to a debtor shareholder. The analysis is similar to the one for partnership distributions covered by Rev. Rul. 93-7, discussed previously.

Modifying the facts of Rev. Rul. 2004-79, assume that a shareholder borrows money from his corporation. The face amount of the debt is $1,000, and the issue price is $920. The original issue discount (OID) of $80 is amortized by both the corporation and the shareholder. At a time when the adjusted issue price and basis are $950 but the FMV is only $925, the corporation distributes the debt to the shareholder as a dividend.

From the corporation’s point of view, this is a property dividend. Rev. Rul. 2004- 79 cites Rev. Rul. 93-7, but it could just as easily have cited Kniffen . As a property dividend, the transaction’s taxa tion to the corporation is governed by Sec. 311. Since the value in the revenue ruling was less than the basis, the corporation recognized no gain or loss. If the value had appreciated, the corporation would have recognized gain equal to the appreciation.

The shareholder receives a taxable dividend equal to the value of the debt; consequently, the debt has a basis equal to its FMV of $925. Since the debt is automatically extinguished, the shareholder is treated as having satisfied an obligation in the amount of $950 with a payment of $925. Therefore, the shareholder must recognize $25 of COD income.

A second fact pattern in the revenue ruling is the same, except the value of the distributed debt is $1,005. Under these facts, the shareholder would be entitled to an interest expense deduction under Regs. Sec. 1.163-4 or 1.163-7 in the amount of $55 ($1,005 − $950). In other words, the shareholder is deemed to have reacquired its own debt for a payment equal to the basis that the distributed debt obtains in the transaction.

The conclusions of Rev. Rul. 2004-79 are consistent with those in Rev. Rul. 93-7. They follow the reasoning of Kniffen .

Another transaction that could occur involving shareholder debt is a liquidation of the corporation, resulting in a distribution of the debt to the debtor/shareholder. The results should be similar to those in Rev. Rul. 2004-79. The corporation that distributes the debt is taxed under Sec. 336. Therefore, the corporation recognizes gain or loss depending on the basis of the debt and its FMV. This is the same result as in the dividend case, except that the loss is recognized under Sec. 336 instead of being denied under Sec. 311. The shareholder’s basis in the debt is its FMV under Sec. 334(a). The shareholder recognizes COD income or interest expense, depending on whether the basis is less than or greater than the adjusted issue price of the debt. These results flow from the regulations under Secs. 61 and 163 and are consistent with the conclusions in the above revenue rulings.

The results change slightly if the liquidation qualifies under Secs. 332 and 337. The IRS discussed these results in Chief Counsel Advice 200040009. 26 Sec. 332 shields the parent from recognition of income on the receipt of the debt. Sec. 337 shields the liquidating corporation from recognizing gain or loss on the transfer of the debt to its parent corporation. The basis is carryover basis under Sec. 334(b). Then, because the debt is extinguished, the parent recognizes either COD income or interest expense on the extinguishment of the debt. As in the prior revenue rulings and Kniffen , the extinguishment has to be a taxable event because the elimination of the carryover basis prevents the parent corporation from having a taxable transaction in the future involving this debt. These results are consistent with prior decisions.

The results discussed for a parent/subsidiary liquidation should also apply if the debtor/corporation acquires a corporation that owns its debt in a nontaxable asset reorganization. In this case, Sec. 361 replaces Secs. 332 and 337. The extinguishment of the debt is a separate transaction that should result in recognition of income or expense.

Acquired Debt

So far, this article has discussed transactions between the debtor and creditor. Now it turns to how the holder of the debt acquired it. In many cases, the holder acquired the debt directly from the debtor, and the acquisition is nontaxable. In other situations, the debt is outstanding and in the hands of an unrelated party. The holder acquires the debt from this unrelated party. In these cases, Sec. 108(e)(4) may create COD income.

Under Sec. 61, if a debtor reacquires its debt for less than its adjusted issue price, the debtor has COD income. Sec. 108(e)(4) expands on this rule: If a party related to the debtor acquires the debt, the debtor is treated as acquiring the debt, with the resulting COD income recognized. Related parties are defined in Secs. 267(b) and 707(b)(1).

The regulations provide that the acquisition can be either direct or indirect. A direct acquisition is one by a person related to the debtor at the time the debt is acquired. 27 An indirect acquisition occurs when the debtor acquires the holder of the debt instrument, where the holder of the debt acquired it in anticipation of becoming related to the debtor. 28 The determination of whether the holder acquired the debt in anticipation of becoming related is based on all the facts and circumstances. 29 However, if the holder acquires the debt within six months before the holder becomes related to the debtor, the acquisition by the holder is deemed to be in anticipation of becoming related to the debtor. 30

In the case of a direct acquisition, the amount of COD income is equal to the adjusted issue price minus the basis of the debt in the hands of the related party. In the case of indirect acquisitions, the calculation depends on whether the debt is acquired within six months of being acquired. 31 If the holder acquired the debt within six months of being acquired, the COD income is calculated as if it were a direct acquisition. If the holder acquired the debt more than six months before being acquired, the COD income is equal to the adjusted issue price minus the FMV of the debt instrument on the date that the holder is acquired.

When a debtor reacquires its own debt, in addition to reporting COD income, the debtor has the debt extinguished as a result of the merger of interests. When a related party acquires the debt, the debtor has COD income, but the debt remains outstanding. In these cases, the debtor is treated as issuing a new debt instrument immediately following the recognition of the COD income for an amount equal to the amount used to calculate the COD income (adjusted basis or FMV 32 ). If this issue price is less than the stated redemption price at maturity of the debt (as defined in Sec. 1273(a)(2), the difference is OID that is subject to the amortization rules of Sec. 1272.

Rev. Rul. 2004-79 provides a simple example of this transaction. In the ruling, a parent corporation, P , issued $10 million of debt for $10 million. After issuance, S , a subsidiary of P , purchased the debt for $9.5 million. Under Regs. Sec. 1.108-2(f), P had to recognize $500,000 of COD income ($10 million face − $9.5 million basis to S ). After this recognition, P was treated as having issued the debt to S for $9.5 million. Therefore, $500,000 of OID was amortizable by P and S . If S later transfers the debt to P , the previously discussed rules determine the taxation of the transfer using S ’s basis ($9.5 million + amortized OID).

Secs. 61 and 108(e)(4) apply only if the debt is acquired for less than the adjusted issue price. If the acquisition price is greater than the adjusted issue price, the acquiring party treats this excess as premium and amortizes it, thereby reducing the amount of interest income recognized by the holder.

Installment Obligations

An installment obligation differs from other obligations in that the holder recognizes income when cash is collected in payment of the obligation. The rules describing the taxation of installment obligations were rewritten as part of the Installment Sales Revision Act of 1980, P.L. 96-471. Under old Sec. 453(d) (new Sec. 453B(a)), if the holder of an installment obligation distributes, transmits, or disposes of the obligation, the taxpayer is required to recognize gain or loss equal to the difference between the basis in the obligation and the FMV of the obligation. There is an exception to this rule for distributions in liquidation of a subsidiary that are exempt from taxation under Sec. 337.

Prior to the Code revision, the regulations permitted the transfer of installment obligations without gain recognition if the transaction was covered by either Sec. 721 or 351. 33 Although the regulations have not been revised for the Code change, the IRS continues to treat Secs. 721 and 351 as overriding the gain recognition provision. 34

If the transaction results in transfer of the obligation either from the creditor to the debtor or from the debtor to the creditor, the tax result changes. The seminal case is Jack Ammann Photogrammetric Engineers, Inc. 35 In it, the taxpayer created a corporation to which he contributed $100,000 in return for 78% of the corporation’s stock. He then sold his photogrammetry business to the corporation for $817,031. He received $100,000 cash and a note for $717,031. He reported the sale under the installment method. When he was still owed $540,223 on the note, he transferred it to the corporation for stock of the corporation worth $540,223. He reported this as a disposition under Sec. 453(d) and recognized the deferred gain. Later, he filed a claim for refund, arguing that Sec. 351 prevented recognition of the deferred gain. After allowing the refund, the IRS assessed a deficiency against the corporation, arguing that the corporation came under Sec. 453(d). The corporation argued that, under Sec. 1032, it was not taxable. The Tax Court ruled for the IRS.

The Fifth Circuit reversed the decision. The underlying reasoning was that the disposition by the shareholder and the extinguishment of the debt in the hands of the corporation were separate transactions. The extinguishment did not fall under Sec. 453(d). The court indicated that the IRS should have assessed the tax against the shareholder.

Following this case, the IRS issued Rev. Rul. 73-423. 36 In this ruling, a shareholder transferred an installment obligation from Corporation X back to the corporation in a transaction described in Sec. 351. The ruling concluded that the transfer was a satisfaction of the installment agreement at other than face value under Sec. 453(d)(1)(A) and that the shareholder was required to recognize gain without regard to Sec. 351. The corporation had no gain or loss under Sec. 1032 and Ammann .

Sec. 453(d) is now Sec. 453B(a), and the rule has not changed. Therefore, if a creditor transfers an installment obligation to the debtor in an otherwise tax-free transaction, the obligation is treated as satisfied at other than its face value, and the creditor is required to recognize gain or loss as discussed in Rev. Rul. 73-423. 37

New Sec. 453B(f) covers transactions in which installment obligations become unenforceable. This section covers the extinguishment of an installment debt through a merger of the rights of a debtor and creditor. The Code treats these transactions as dispositions of the obligation with gain or loss recognized. When the debtor and creditor are related, the disposition is at FMV but no less than the face amount.

If the debtor of an installment obligation engages in a transaction in which the creditor assumes the debt, the results are consistent with those of transactions involving obligations other than installment notes. The debtor is deemed to have received cash equal to the amount of the debt. This is fully taxable unless exempted by Sec. 357, 721, or a similar provision. The creditor falls under Sec. 453B(f), with the extinguishment treated as a taxable disposition of the obligation for its FMV (which for related parties is no less than the face amount).

Business entities often incur debts to their owners, and, conversely, the owners incur liabilities to their business entities. In numerous transactions these obligations are canceled for consideration other than simple repayment of the debt. Based on Kniffen , these transactions are treated as a transfer of consideration followed by an extinguishment of the debt. If a shareholder’s debt to his or her controlled corporation is transferred to that corporation along with assets, the transaction may be tax free under Secs. 351 and 357(a). If a shareholder/creditor receives the related corporate debt in a distribution or liquidation, Sec. 311 or 336 determines the corporation’s taxation.

The cancellation of a partner’s debt to the partnership is generally governed by the distribution rules, including the constructive sale or compensation rules of Sec. 707(a)(2). When a partner cancels the partnership’s debt, the partner has made a contribution to capital. This can have consequences to all partners since the total liabilities are decreased and the partners’ bases are decreased under Sec. 752.

In most cases the merger of debtor and creditor interests is nontaxable. However, if the basis of the debt or receivable does not equal the face amount of the debt, income or loss is recognized. The exact amount and character of the income or loss depends on factors discussed in this article. It is important for the tax adviser to identify those cases in which the debt transfer is not tax free.

1 Invalid loans to shareholders have been reclassified as dividends.

2 Kniffen , 39 T.C. 553 (1962).

3 Edwards Motor Transit Co. , T.C. Memo. 1964-317.

4 Estate of Gilmore , 40 B.T.A. 945 (1939).

5 Rev. Rul. 72-464, 1972-2 C.B. 214.

6 GCM 34902 (6/8/72). The GCM also refers to Sec. 332, which will be dis cussed later.

7 As the GCM points out, by using Sec. 357(a), taxpayers could achieve the same outcome in C reorganizations.

8 See Chief Counsel Advice 200040009 (10/6/00), which suggests Estate of Gilmore ’s requirement of a formal cancellation of debt before COD income is recognized may no longer be valid.

9 General Utilities & Operating Co. v. Helvering , 296 U.S. 200 (1935).

10 Sec. 334(b)(1).

12 Regs. Sec. 1.707-5(a)(6).

13 If the partnership transfers money or other consideration in the transaction, the amount treated as sales proceeds may be limited under Regs. Sec. 1.707-5(a)(5)(i)(B).

14 Under Regs. Sec. 1.707-5(a)(3)(ii), a partner’s share of liabilities is reduced by liabilities assumed that are anticipated to be reduced. Based on Kniffen and Edwards , the reduction will be anticipated.

15 Notice 94-47, 1994-1 C.B. 357.

16 See, e.g., IRS Letter Ruling 8825048 (3/23/88).

17 The transaction that gives rise to the difference and the taxation that results are discussed later.

18 Rev. Rul. 72-464, 1972-2 C.B. 214. Although this is a debtor-to-creditor transfer, the result is the same.

19 See GCM 34902 (6/8/72).

20 Rev. Rul. 93-7, 1993-1 C.B. 125.

21 If the partnership makes a Sec. 754 election, the partnership has a Sec. 734 adjustment of $75 ($100 inside basis – $25 basis after distribution).

22 IRS Letter Ruling 201105016 (2/4/11).

23 Regs. Sec. 1.108-8, effective Nov. 17, 2011.

24 See the Regs. Sec. 1.108-8(b)(2) safe-harbor rule.

25 Rev. Rul. 2004-79, 2004-2 C.B. 106.

26 CCA 200040009 (10/6/00).

27 Regs. Sec. 1.108-2(b).

28 Regs. Sec. 1.108-2(c)(1).

29 Regs. Sec. 1.108-2(c)(2).

30 Regs. Sec. 1.108-2(c)(3).

31 Regs. Secs. 1.108-2(f)(1) and (2).

32 Regs. Sec. 1.108-2(g).

33 Regs. Sec. 1.453-9(c)(2).

34 See IRS Letter Rulings 8824044 (3/22/88) and 8425042 (3/19/84).

35 Jack Ammann Photogrammetric Engineers, Inc. , 341 F.2d 466 (5th Cir. 1965), rev’g 39 T.C. 500 (1962).

36 Rev. Rul. 73-423, 1973-2 C.B. 161.

37 Although this revenue ruling involved a corporation, the IRS believes the same rule applies to partnerships. Treasury is currently working on a revision of the regulations to clarify the results. See the preamble to Regs. Sec. 1.108-8, T.D. 9557 (11/17/11).

A process of experimentation: Production expenses for the R&D tax credit

Regulations create a new approach to the creditability of foreign taxes, like-kind exchanges of real estate: back to basics, bidding farewell to us citizenship: understanding the exit tax, pillar two and nonprofit organizations.

TAX PRACTICE MANAGEMENT

To get through the rigors of tax season, CPAs depend on their tax preparation software. Here's how they rate the leading professional products.

EMPLOYEE BENEFITS & PENSIONS

The 2022 act affected a wide array of retirement fund and pension plan provisions. This article highlights many of the most noteworthy ones, along with relevant IRS guidance and congressional plans for technical corrections.