Publication 541
Partnerships

For use in preparing 2002 Returns

Partnership Income
or Loss

A partnership computes its income and files its return in the same manner as an individual. However, certain deductions are not allowed to the partnership.

Separately stated items.   Certain items must be separately stated on the partnership return and included as separate items on the partners' returns. These items, listed on Schedule K (Form 1065), are the following.

• Ordinary income or loss from trade or business activities.
• Net income or loss from rental real estate activities.
• Net income or loss from other rental activities.
• Gains and losses from sales or exchanges of capital assets.
• Gains and losses from sales or exchanges of property described in section 1231 of the Internal Revenue Code.
• Charitable contributions.
• Dividends (passed through to corporate partners) that qualify for the dividends-received deduction.
• Taxes paid or accrued to foreign countries and U.S. possessions.
• Other items of income, gain, loss, deduction, or credit, as provided by regulations. Examples include nonbusiness expenses, intangible drilling and development costs, and soil and water conservation expenses.

Elections.   The partnership makes most choices about how to figure income. These include choices for the following items.

• Accounting method.
• Depreciation method.
• Method of accounting for specific items, such as depletion or installment sales.
• Nonrecognition of gain on involuntary conversions of property.
• Amortization of certain organization fees and business start-up costs of the partnership.

However, each partner chooses how to treat the partner's share of foreign and U.S. possessions taxes, certain mining exploration expenses, and income from cancellation of debt.

More information.   For more information on a specific election, see the listed publication.

• Accounting methods: Publication 538.
• Depreciation methods: Publication 946.
• Installment sales: Publication 537.
• Amortization and depletion: Publication 535, chapters 9 and 10.
• Involuntary conversions: Publication 544 (condemnations) and Publication 547 (casualties and thefts).

Organization expenses and syndication fees.   Neither the partnership nor any partner can deduct, as a current expense, amounts paid or incurred to organize a partnership or to promote the sale of, or to sell, an interest in the partnership.

The partnership can choose to amortize certain organization expenses over a period of not less than 60 months. The period must start with the month the partnership begins business. This election is irrevocable and the period the partnership chooses in this election cannot be changed. If the partnership elects to amortize these expenses and is liquidated before the end of the amortization period, the remaining balance in this account is deductible as a loss.

Making the election.   The election to amortize organization expenses is made by attaching a statement to the partnership's return for the tax year the partnership begins its business. The statement must provide all the following information.

• A description of each organization expense incurred (whether or not paid).
• The amount of each expense.
• The date each expense was incurred.
• The month the partnership began its business.
• The number of months (not less than 60) over which the expenses are to be amortized.

Expenses less than $10 need not be separately listed, provided the total amount is listed with the dates on which the first and last of the expenses were incurred. A cash basis partnership must also indicate the amount paid before the end of the year for each expense.

Amortizable expenses.   Amortization applies to expenses that are:

1. Incident to the creation of the partnership,
2. Chargeable to a capital account, and
3. The type that would be amortized if they were incurred in the creation of a partnership having a fixed life.

To satisfy (1), an expense must be incurred during the period beginning at a point that is a reasonable time before the partnership begins business and ending with the date for filing the partnership return (not including extensions) for the tax year in which the partnership begins business. In addition, the expense must be for creating the partnership and not for starting or operating the partnership trade or business.

To satisfy (3), the expense must be for a type of item normally expected to benefit the partnership throughout its entire life.

Organization expenses that can be amortized include the following.

• Legal fees for services incident to the organization of the partnership, such as negotiation and preparation of a partnership agreement.
• Accounting fees for services incident to the organization of the partnership.
• Filing fees.

Expenses not amortizable.   Expenses that cannot be amortized (regardless of how the partnership characterizes them) include expenses connected with the following actions.

• Acquiring assets for the partnership or transferring assets to the partnership.
• Admitting or removing partners other than at the time the partnership is first organized.
• Making a contract relating to the operation of the partnership trade or business (even if the contract is between the partnership and one of its members).
• Syndicating the partnership. Syndication expenses, such as commissions, professional fees, and printing costs connected with the issuing and marketing of interests in the partnership, are capitalized. They can never be deducted by the partnership, even if the syndication is unsuccessful.

Partner's Income
or Loss

A partner's income or loss from a partnership is the partner's distributive share of partnership items for the partnership's tax year that ends with or within the partner's tax year. These items are reported to the partner on Schedule K-1 (Form 1065).

Gross income.   When it is necessary to determine the gross income of a partner, the partner's gross income includes his or her distributive share of the partnership's gross income. For example, the partner's share of the partnership gross income is used in determining whether an income tax return must be filed by that partner.

Estimated tax.   Partners may have to make payments of estimated tax during the year as a result of partnership income.

Generally, estimated tax for individuals is the smaller of the following amounts, reduced by any expected withholding and credits.

1. 90% of the tax expected to be shown on the current year's tax return.
2. 100% of the total tax shown on the prior year's tax return.

Different rules apply to certain higher income individuals and individuals who receive at least two-thirds of their gross income from farming or fishing.

See Publication 505 for more information.

Self-employment income.   A partner is not an employee of the partnership. The partner's distributive share of ordinary income from a partnership is generally included in figuring net earnings from self-employment. However, a limited partner generally does not include his or her distributive share of income or loss in computing net earnings from self-employment. This exclusion does not apply to guaranteed payments made to a limited partner for services actually rendered to or on behalf of a partnership engaged in a trade or business.

Self-employment tax.   If an individual partner has net earnings from self-employment of $400 or more for the year, the partner must figure self-employment tax on Schedule SE (Form 1040). For more information on self-employment tax, see Publication 533.

Alternative minimum tax.   To figure alternative minimum tax, a partner must separately take into account any distributive share of items of income and deductions that enter into the computation of alternative minimum taxable income. For information on which items of income and deductions are affected, see the Form 6251 instructions.

Partners of electing large partnerships should see the Partner's Instructions for Schedule K-1 (Form 1065-B), for information on alternative minimum tax.

Figuring Distributive Share

Generally, the partnership agreement determines a partner's distributive share of any item or class of items of income, gain, loss, deduction, or credit. However, the allocations provided for in the partnership agreement or any modification will be disregarded if they do not have substantial economic effect. If the partnership agreement does not provide for an allocation, or an allocation does not have substantial economic effect, the partner's distributive share of the partnership items is generally determined by the partner's interest in the partnership. For special allocation rules for items attributable to built-in gain or loss on property contributed by a partner, see Contribution of Property under Transactions Between Partnership and Partners, later.

Substantial economic effect.   An allocation has substantial economic effect if both of the following tests are met.

• There is a reasonable possibility that the allocation will substantially affect the dollar amount of the partners' shares of partnership income or loss independently of tax consequences.
• The partner to whom the allocation is made actually receives the economic benefit or bears the economic burden corresponding to that allocation.

Allocation attributable to a nonrecourse liability.   An allocation of a loss, deduction, or expense attributable to a partnership nonrecourse liability does not have any economic effect because the partner does not bear the economic burden corresponding to that allocation. (See Effect of Partnership Liabilities under Basis of Partner's Interest, later.) Therefore, the partner's distributive share of the item must be determined by his or her interest in the partnership. For more information, see section 1.704-2 of the regulations.

Partner's interest in partnership.   If a partner's distributive share of a partnership item cannot be determined under the partnership agreement, it is determined by his or her interest in the partnership. The partner's interest is determined by taking into account all the following items.

• The partners' relative contributions to the partnership.
• The interests of all partners in economic profits and losses (if different from interests in taxable income or loss) and in cash flow and other nonliquidating distributions.
• The rights of the partners to distributions of capital upon liquidation.

Varying interests.   A change in a partner's interest during the partnership's tax year requires the partner's distributive share of partnership items to be determined by taking into account his or her varying interests in the partnership during the tax year. Partnership items are allocated to the partner only for the portion of the year in which he or she is a member of the partnership.

This rule applies to a partner who sells or exchanges part of an interest in a partnership, or whose interest is reduced or increased (whether by entry of a new partner, partial liquidation of a partner's interest, gift, additional contributions, or otherwise).

Example.   ABC is a calendar year partnership with three partners, Alan, Bob, and Cathy. Under the partnership agreement, profits and losses are shared in proportion to each partner's contributions. On January 1 the ratio was 90% for Alan, 5% for Bob, and 5% for Cathy. On December 1 Bob and Cathy each contributed additional amounts. The new profit and loss sharing ratios were 30% for Alan, 35% for Bob, and 35% for Cathy. For its tax year ended December 31, the partnership had a loss of $1,200. This loss occurred equally over the partnership's tax year. The loss is divided among the partners as follows: