EA Part 2 Partnership Taxation: Contributions, Allocations, and Distributions

Partnership taxation sits at the intersection of several complex Code sections, and Part 2 tests it heavily. The rules that govern how partnerships form, allocate income, make distributions, and are liquidated are more intricate than those for any other entity type on the exam. Building a solid mental model of the relationship between partners and the partnership — and keeping inside basis and outside basis distinct — is the key to handling these questions efficiently.

Partnership Formation: Section 721 Non-Recognition

When a partner contributes property to a partnership in exchange for a partnership interest, neither the partner nor the partnership generally recognizes gain or loss under Section 721. This mirrors the Section 351 rule for corporations, but with fewer restrictions — no control requirement, no 80% ownership threshold.

The partner takes a carryover basis in the partnership interest equal to the adjusted basis of the contributed property. The partnership takes the same carryover basis in the contributed property. If a partner contributes property with a built-in gain or loss, that pre-contribution gain or loss must be allocated back to the contributing partner when the property is eventually sold — this is the Section 704(c) rule.

A contribution is taxable when it is disguised as a sale, or when the partner receives a distribution of other property within two years of contributing property.

Outside Basis

A partner's outside basis is the basis the partner holds in the partnership interest itself. It starts with the amount contributed and adjusts each year:

• Increases: Partner's distributive share of partnership income (including tax-exempt income), partner's share of partnership liabilities
• Decreases: Distributions received, partner's distributive share of losses and deductions, decreases in the partner's share of partnership liabilities

Partnership liabilities are a crucial component. Under Section 752, a partner's share of partnership debt increases outside basis. For recourse liabilities, the increase goes to the partner who bears the economic risk of loss. For nonrecourse liabilities, the increase is generally allocated based on profit-sharing ratios (with adjustments for Section 704(c) property).

Outside basis cannot go below zero. Losses that exceed outside basis are suspended and carry forward.

Partnership Allocations and Substantial Economic Effect

Partnerships have flexibility in allocating income, gains, losses, deductions, and credits among partners — but allocations must have substantial economic effect to be respected by the IRS. If they lack substantial economic effect, items are reallocated based on the partners' interests in the partnership.

An allocation has economic effect if:

1. It is reflected in the partners' capital accounts
2. Liquidating distributions are made in accordance with positive capital account balances
3. Partners with deficit capital accounts are required to restore the deficit

The economic effect is substantial if it meaningfully affects the partners' after-tax economic positions in a way that is not transitory or offsetting.

Guaranteed Payments

Guaranteed payments are fixed amounts paid to a partner for services or the use of capital, without regard to partnership income. They are treated as:

• Ordinary income to the receiving partner — reported on Schedule E and subject to self-employment tax
• Deductible by the partnership (if ordinary and necessary business expenses), reducing the income allocated to other partners

Guaranteed payments are not distributions. They do not reduce the partner's outside basis. They are analogous to a salary or interest payment to an unrelated party, except they are paid to a partner.

Current vs. Liquidating Distributions

Current (non-liquidating) distributions reduce the partner's outside basis but do not trigger gain or loss recognition in most cases. The partner takes a basis in distributed property equal to the lesser of the property's inside basis or the partner's remaining outside basis. Hot assets (inventory and unrealized receivables under Section 751) can trigger ordinary income on distributions that shift these items disproportionately.

Liquidating distributions close out the partner's interest entirely. Gain is recognized only if the partner receives cash (or marketable securities treated as cash) in excess of outside basis. Loss can only be recognized if the distribution consists solely of cash, unrealized receivables, and inventory — and the amount is less than outside basis.

Section 754 Election

When a partner sells a partnership interest or when a partner dies, a mismatch often arises between the new partner's outside basis and their share of inside basis in partnership assets. Without adjustment, the new partner is taxed on gains already inherent in the assets when they acquired the interest.

The Section 754 election allows the partnership to adjust the basis of its assets (a Section 743(b) adjustment) to reflect the new partner's outside basis. The adjustment is calculated as the difference between the new partner's outside basis and their share of the partnership's inside basis.

The election is made by attaching a statement to the partnership return for the year it is to take effect. Once made, the election is binding on all subsequent transfers until revoked with IRS consent.

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