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Free income tax Publication 541 - Main Content Table of Contents Forming a PartnershipOrganizations Classified as Partnerships Family Partnership Partnership Agreement Terminating a PartnershipIRS e-file (Electronic Filing) Exclusion From Partnership Rules Partnership Return (Form 1065) Partnership DistributionsSubstantially appreciated inventory items. Free income tax Partner's Gain or Loss Partner's Basis for Distributed Property Transactions Between Partnership and PartnersGuaranteed Payments Sale or Exchange of Property Contribution of Property Contribution of Services Basis of Partner's InterestAdjusted Basis Effect of Partnership Liabilities Disposition of Partner's InterestSale, Exchange, or Other Transfer Payments for Unrealized Receivables and Inventory Items Liquidation at Partner's Retirement or Death Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)Partnership Item. Free income tax Small Partnerships and the Small Partnership Exception Small Partnership TEFRA Election Role of Tax Matters Partner (TMP) in TEFRA Proceedings Statute of Limitations and TEFRA Amended Returns and Administrative Adjustment Requests (AARs) How To Get Tax Help Forming a Partnership The following sections contain general information about partnerships. Free income tax 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. Free income tax However, a joint undertaking merely to share expenses is not a partnership. Free income tax For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants. Free income tax The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed after 1996. Free income tax Organizations formed after 1996. Free income tax   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. Free income tax An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic. Free income tax An organization formed under a state law that refers to it as a joint-stock company or joint-stock association. Free income tax An insurance company. Free income tax Certain banks. Free income tax An organization wholly owned by a state, local, or foreign government. Free income tax An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships). Free income tax Certain foreign organizations identified in section 301. Free income tax 7701-2(b)(8) of the regulations. Free income tax A tax-exempt organization. Free income tax A real estate investment trust. Free income tax An organization classified as a trust under section 301. Free income tax 7701-4 of the regulations or otherwise subject to special treatment under the Internal Revenue Code. Free income tax Any other organization that elects to be classified as a corporation by filing Form 8832. Free income tax For more information, see the instructions for Form 8832. Free income tax Limited liability company. Free income tax   A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. Free income tax Unlike a partnership, none of the members of an LLC are personally liable for its debts. Free income tax 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. Free income tax 7701-3. Free income tax See Form 8832 and section 301. Free income tax 7701-3 of the regulations for more details. Free income tax A domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes. Free income tax Organizations formed before 1997. Free income tax   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 does not elect to be classified as a corporation by filing Form 8832. Free income tax Community property. Free income tax    Spouses who own a qualified entity (defined later) can choose to classify the entity as a partnership for federal tax purposes by filing the appropriate partnership tax returns. Free income tax 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. Free income tax A change in reporting position will be treated for federal tax purposes as a conversion of the entity. Free income tax   A qualified entity is a business entity that meets all the following requirements. Free income tax 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. Free income tax No person other than one or both spouses would be considered an owner for federal tax purposes. Free income tax The business entity is not treated as a corporation. Free income tax   For more information about community property, see Publication 555, Community Property. Free income tax Publication 555 discusses the community property laws of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Free income tax Family Partnership Members of a family can be partners. Free income tax However, family members (or any other person) will be recognized as partners only if one of the following requirements is met. Free income tax If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest. Free income tax If capital is not a material income-producing factor, they joined together in good faith to conduct a business. Free income tax They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner. Free income tax Capital is material. Free income tax   Capital is a material income-producing factor if a substantial part of the gross income of the business comes from the use of capital. Free income tax Capital is ordinarily an income-producing factor if the operation of the business requires substantial inventories or investments in plants, machinery, or equipment. Free income tax Capital is not material. Free income tax   In general, capital is not a material income-producing factor if the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership. Free income tax Capital interest. Free income tax   A capital interest in a partnership is an interest in its assets that is distributable to the owner of the interest in either of the following situations. Free income tax The owner withdraws from the partnership. Free income tax The partnership liquidates. Free income tax   The mere right to share in earnings and profits is not a capital interest in the partnership. Free income tax Gift of capital interest. Free income tax   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. Free income tax It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the partnership. Free income tax 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. Free income tax Purchase. Free income tax   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. Free income tax The fair market value of the purchased interest is considered donated capital. Free income tax For this purpose, members of a family include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons). Free income tax Example. Free income tax A father sold 50% of his business to his son. Free income tax The resulting partnership had a profit of $60,000. Free income tax Capital is a material income-producing factor. Free income tax The father performed services worth $24,000, which is reasonable compensation, and the son performed no services. Free income tax The $24,000 must be allocated to the father as compensation. Free income tax Of the remaining $36,000 of profit due to capital, at least 50%, or $18,000, must be allocated to the father since he owns a 50% capital interest. Free income tax The son's share of partnership profit cannot be more than $18,000. Free income tax Business owned and operated by spouses. Free income tax   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. Free income tax If so, they should report income or loss from the business on Form 1065. Free income tax They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor. Free income tax However, the spouses can elect not to treat the joint venture as a partnership by making a Qualified Joint Venture Election. Free income tax Qualified Joint Venture Election. Free income tax   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. Free income tax 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 LLC. Free income tax   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 does not have a Form 1065 filing requirement. Free income tax All items of income, gain, deduction, loss, and credit are divided between the spouses based on their respective interests in the venture. Free income tax Each spouse takes into account his or her respective share of these items as a sole proprietor. Free income tax Each spouse would account for his or her respective share on the appropriate form, such as Schedule C (Form 1040). Free income tax 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 (i. Free income tax e. Free income tax , based on their respective interests in the venture). Free income tax   If the spouses do not make the election to treat their respective interests in the joint venture as sole proprietorships, each spouse should carry his or her share of the partnership income or loss from Schedule K-1 (Form 1065) to their joint or separate Form(s) 1040. Free income tax Each spouse should include his or her respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax. Free income tax   This generally does not increase the total tax on the return, but it does give each spouse credit for social security earnings on which retirement benefits are based. Free income tax However, this may not be true if either spouse exceeds the social security tax limitation. Free income tax   For more information on qualified joint ventures, go to IRS. Free income tax gov, enter “Election for Qualified Joint Ventures” in the search box and select the link reading “Election for Husband and Wife Unincorporated Businesses. Free income tax ” Partnership Agreement The partnership agreement includes the original agreement and any modifications. Free income tax The modifications must be agreed to by all partners or adopted in any other manner provided by the partnership agreement. Free income tax The agreement or modifications can be oral or written. Free income tax 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. Free income tax This filing date does not include any extension of time. Free income tax If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part of the agreement. Free income tax Terminating a Partnership A partnership terminates when one of the following events takes place. Free income tax 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. Free income tax At least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner. Free income tax Unlike other partnerships, an electing large partnership does not terminate on the sale or exchange of 50% or more of the partnership interests within a 12-month period. Free income tax See section 1. Free income tax 708-1(b) of the regulations for more information on the termination of a partnership. Free income tax For special rules that apply to a merger, consolidation, or division of a partnership, see sections 1. Free income tax 708-1(c) and 1. Free income tax 708-1(d) of the regulations. Free income tax Date of termination. Free income tax   The partnership's tax year ends on the date of termination. Free income tax For the event described in (1), above, the date of termination is the date the partnership completes the winding up of its affairs. Free income tax For the event described in (2), above, the date of termination is the date of the sale or exchange of a partnership interest that, by itself or together with other sales or exchanges in the preceding 12 months, transfers an interest of 50% or more in both capital and profits. Free income tax Short period return. Free income tax   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. Free income tax The return is due the 15th day of the fourth month following the date of termination. Free income tax See Partnership Return (Form 1065), later, for information about filing Form 1065. Free income tax Conversion of partnership into limited liability company (LLC). Free income tax   The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate the partnership. Free income tax The conversion is not a sale, exchange, or liquidation of any partnership interest; the partnership's tax year does not close; and the LLC can continue to use the partnership's taxpayer identification number. Free income tax   However, the conversion may change some of the partners' bases in their partnership interests if the partnership has recourse liabilities that become nonrecourse liabilities. Free income tax Because the partners share recourse and nonrecourse liabilities differently, their bases must be adjusted to reflect the new sharing ratios. Free income tax If a decrease in a partner's share of liabilities exceeds the partner's basis, he or she must recognize gain on the excess. Free income tax For more information, see Effect of Partnership Liabilities under Basis of Partner's Interest, later. Free income tax   The same rules apply if an LLC classified as a partnership is converted into a partnership. Free income tax IRS e-file (Electronic Filing) Please click here for the text description of the image. Free income tax e-file Certain partnerships with more than 100 partners are required to file Form 1065, Schedules K-1, and related forms and schedules electronically (e-file). Free income tax Other partnerships generally have the option to file electronically. Free income tax For details about IRS e-file, see the Form 1065 instructions. Free income tax 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. Free income tax All the partners must agree to make the choice, and the partners must be able to compute their own taxable income without computing the partnership's income. Free income tax 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. Free income tax 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. Free income tax Investing partnership. Free income tax   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. Free income tax They own the property as co-owners. Free income tax They reserve the right separately to take or dispose of their shares of any property acquired or retained. Free income tax They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange the investment property. Free income tax Each separate participant can delegate authority to purchase, sell, or exchange his or her share of the investment property for the time being for his or her account, but not for a period of more than a year. Free income tax Operating agreement partnership. Free income tax   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. Free income tax They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights. Free income tax They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used. Free income tax They do not jointly sell services or the property produced or extracted. Free income tax Each separate participant can delegate authority to sell his or her share of the property produced or extracted for the time being for his or her account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year. Free income tax However, this exclusion does not apply to an unincorporated organization one of whose principal purposes is cycling, manufacturing, or processing for persons who are not members of the organization. Free income tax Electing the exclusion. Free income tax   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. Free income tax This filing date includes any extension of time. Free income tax See Regulations section 1. Free income tax 761-2(b) for the procedures to follow. Free income tax Partnership Return (Form 1065) 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. Free income tax The partnership return must show the names and addresses of each partner and each partner's distributive share of taxable income. Free income tax The return must be signed by a general partner. Free income tax If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return. Free income tax 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. Free income tax See the Instructions for Form 1065 for more information about who must file Form 1065. Free income tax Partnership Distributions Partnership distributions include the following. Free income tax A withdrawal by a partner in anticipation of the current year's earnings. Free income tax A distribution of the current year's or prior years' earnings not needed for working capital. Free income tax A complete or partial liquidation of a partner's interest. Free income tax A distribution to all partners in a complete liquidation of the partnership. Free income tax A partnership distribution is not taken into account in determining the partner's distributive share of partnership income or loss. Free income tax If any gain or loss from the distribution is recognized by the partner, it must be reported on his or her return for the tax year in which the distribution is received. Free income tax 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. Free income tax Effect on partner's basis. Free income tax   A partner's adjusted basis in his or her partnership interest is decreased (but not below zero) by the money and adjusted basis of property distributed to the partner. Free income tax See Adjusted Basis under Basis of Partner's Interest, later. Free income tax Effect on partnership. Free income tax   A partnership generally does not recognize any gain or loss because of distributions it makes to partners. Free income tax The partnership may be able to elect to adjust the basis of its undistributed property. Free income tax Certain distributions treated as a sale or exchange. Free income tax   When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property rather than a distribution. Free income tax Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's interest in other partnership property, including money. Free income tax Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or substantially appreciated inventory items. Free income tax   See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. Free income tax   This treatment does not apply to the following distributions. Free income tax A distribution of property to the partner who contributed the property to the partnership. Free income tax 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. Free income tax Substantially appreciated inventory items. Free income tax   Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the distribution, their total fair market value is more than 120% of the partnership's adjusted basis for the property. Free income tax 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. Free income tax 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. Free income tax Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. Free income tax If partnership property (other than marketable securities treated as money) is distributed to a partner, he or she generally does not recognize any gain until the sale or other disposition of the property. Free income tax For exceptions to these rules, see Distribution of partner's debt and Net precontribution gain, later. Free income tax Also, see Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. Free income tax Example. Free income tax The adjusted basis of Jo's partnership interest is $14,000. Free income tax She receives a distribution of $8,000 cash and land that has an adjusted basis of $2,000 and a fair market value of $3,000. Free income tax Because the cash received does not exceed the basis of her partnership interest, Jo does not recognize any gain on the distribution. Free income tax Any gain on the land will be recognized when she sells or otherwise disposes of it. Free income tax The distribution decreases the adjusted basis of Jo's partnership interest to $4,000 [$14,000 − ($8,000 + $2,000)]. Free income tax Marketable securities treated as money. Free income tax   Generally, a marketable security distributed to a partner is treated as money in determining whether gain is recognized on the distribution. Free income tax This treatment, however, does not generally apply if that partner contributed the security to the partnership or an investment partnership made the distribution to an eligible partner. Free income tax   The amount treated as money is the security's fair market value 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 fair market value 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 fair market value in (1). Free income tax   For more information, including the definition of marketable securities, see section 731(c) of the Internal Revenue Code. Free income tax Loss on distribution. Free income tax   A partner does not recognize loss on a partnership distribution unless all the following requirements are met. Free income tax The adjusted basis of the partner's interest in the partnership exceeds the distribution. Free income tax The partner's entire interest in the partnership is liquidated. Free income tax The distribution is in money, unrealized receivables, or inventory items. Free income tax   There are exceptions to these general rules. Free income tax See the following discussions. Free income tax Also, see Liquidation at Partner's Retirement or Death under Disposition of Partner's Interest, later. Free income tax Distribution of partner's debt. Free income tax   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 fair market value of the debt differs from the basis of the debt (determined under the rules discussed in Partner's Basis for Distributed Property, later). Free income tax   The partner is treated as having satisfied the debt for its fair market value. Free income tax If the issue price (adjusted for any premium or discount) of the debt exceeds its fair market value when distributed, the partner may have to include the excess amount in income as canceled debt. Free income tax   Similarly, a deduction may be available to a corporate partner if the fair market value of the debt at the time of distribution exceeds its adjusted issue price. Free income tax Net precontribution gain. Free income tax   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. Free income tax   The gain recognized is the lesser of the following amounts. Free income tax The excess of: The fair market value 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. Free income tax The “net precontribution gain” of the partner. Free income tax 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. Free income tax For information about the distribution of contributed property to another partner, see Contribution of Property , under Transactions Between Partnership and Partners, later. Free income tax   The character of the gain is determined by reference to the character of the net precontribution gain. Free income tax This gain is in addition to any gain the partner must recognize if the money distributed is more than his or her basis in the partnership. Free income tax For these rules, the term “money” includes marketable securities treated as money, as discussed earlier. Free income tax Effect on basis. Free income tax   The adjusted basis of the partner's interest in the partnership is increased by any net precontribution gain recognized by the partner. Free income tax Other than for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. Free income tax See Basis of Partner's Interest , later. Free income tax   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. Free income tax Exceptions. Free income tax   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. Free income tax For this purpose, the partner's previously contributed property does not 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. Free income tax   Recognition of gain under this rule also does not 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. Free income tax 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. Free income tax However, the basis of the property to the partner cannot be more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction. Free income tax Example 1. Free income tax The adjusted basis of Emily's partnership interest is $30,000. Free income tax She receives a distribution of property that has an adjusted basis of $20,000 to the partnership and $4,000 in cash. Free income tax Her basis for the property is $20,000. Free income tax Example 2. Free income tax The adjusted basis of Steve's partnership interest is $10,000. Free income tax He receives a distribution of $4,000 cash and property that has an adjusted basis to the partnership of $8,000. Free income tax His basis for the distributed property is limited to $6,000 ($10,000 − $4,000, the cash he receives). Free income tax Complete liquidation of partner's interest. Free income tax   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. Free income tax Partner's holding period. Free income tax   A partner's holding period for property distributed to the partner includes the period the property was held by the partnership. Free income tax If the property was contributed to the partnership by a partner, then the period it was held by that partner is also included. Free income tax Basis divided among properties. Free income tax   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. Free income tax For property distributed after August 5, 1997, allocate the basis using the following rules. Free income tax 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. Free income tax If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. Free income tax 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. Free income tax If the allocable basis exceeds the total of these assigned bases, increase the assigned bases by the amount of the excess. Free income tax If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. Free income tax Allocating a basis increase. Free income tax   Allocate any basis increase required in rule (2), above, first to properties with unrealized appreciation to the extent of the unrealized appreciation. Free income tax 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. Free income tax Allocate any remaining basis increase among all the properties in proportion to their respective fair market values. Free income tax Example. Free income tax Eun's basis in her partnership interest is $55,000. Free income tax In a distribution in liquidation of her entire interest, she receives properties A and B, neither of which is inventory or unrealized receivables. Free income tax Property A has an adjusted basis to the partnership of $5,000 and a fair market value of $40,000. Free income tax Property B has an adjusted basis to the partnership of $10,000 and a fair market value of $10,000. Free income tax 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). Free income tax This leaves a $40,000 basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned bases). Free income tax She first allocates $35,000 to property A (its unrealized appreciation). Free income tax The remaining $5,000 is allocated between the properties based on their fair market values. Free income tax $4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is allocated to property B. Free income tax 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). Free income tax Allocating a basis decrease. Free income tax   Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier. Free income tax Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. Free income tax 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. Free income tax Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased in (1)). Free income tax Example. Free income tax Armando's basis in his partnership interest is $20,000. Free income tax In a distribution in liquidation of his entire interest, he receives properties C and D, neither of which is inventory or unrealized receivables. Free income tax Property C has an adjusted basis to the partnership of $15,000 and a fair market value of $15,000. Free income tax Property D has an adjusted basis to the partnership of $15,000 and a fair market value of $5,000. Free income tax 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). Free income tax This leaves a $10,000 basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable basis). Free income tax He allocates the entire $10,000 to property D (its unrealized depreciation). Free income tax Armando's basis in property C is $15,000 and his basis in property D is $5,000 ($15,000 − $10,000). Free income tax Distributions before August 6, 1997. Free income tax   For property distributed before August 6, 1997, allocate the basis using the following rules. Free income tax 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. Free income tax 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. Free income tax Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership. Free income tax Partner's interest more than partnership basis. Free income tax   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. Free income tax Special adjustment to basis. Free income tax   A partner who acquired any part of his or her 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. Free income tax To choose the special adjustment, the partner must have received the distribution within 2 years after acquiring the partnership interest. Free income tax Also, the partnership must not have chosen the optional adjustment to basis when the partner acquired the partnership interest. Free income tax   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. Free income tax 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. Free income tax   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. Free income tax If the choice does not 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. Free income tax   A partner choosing this special basis adjustment must attach a statement to his or her tax return that the partner chooses under section 732(d) of the Internal Revenue Code to adjust the basis of property received in a distribution. Free income tax 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. Free income tax Example. Free income tax Chin Ho purchased a 25% interest in X partnership for $17,000 cash. Free income tax At the time of the purchase, the partnership owned inventory having a basis to the partnership of $14,000 and a fair market value of $16,000. Free income tax 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. Free income tax 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. Free income tax The value of the inventory received was 25% of the value of all partnership inventory. Free income tax (It is immaterial whether the inventory he received was on hand when he acquired his interest. Free income tax ) Since the partnership from which Chin Ho withdrew did not make the optional adjustment to basis, he chose to adjust the basis of the inventory received. Free income tax His share of the partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference between the $16,000 fair market value of the inventory and its $14,000 basis to the partnership at the time he acquired his interest). Free income tax 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. Free income tax 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). Free income tax His basis in the inventory items is $4,000 ($3,500 partnership basis + $500 special adjustment). Free income tax The remaining $11,500 is allocated to his new basis for the other property he received. Free income tax Mandatory adjustment. Free income tax   A partner does not always have a choice of making this special adjustment to basis. Free income tax 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. Free income tax The fair market value of all partnership property (other than money) was more than 110% of its adjusted basis to the partnership. Free income tax 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 could not be depreciated, depleted, or amortized and increased the basis of property that could be. Free income tax The optional basis adjustment, if it had been chosen by the partnership, would have changed the partner's basis for the property actually distributed. Free income tax Required statement. Free income tax   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. Free income tax The statement must provide information necessary for the partner to compute the special basis adjustment. Free income tax Marketable securities. Free income tax   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. Free income tax See Marketable securities treated as money under Partner's Gain or Loss, earlier. Free income tax The basis increase is allocated among the securities in proportion to their respective amounts of unrealized appreciation before the basis increase. Free income tax Transactions Between Partnership and Partners For certain transactions between a partner and his or her partnership, the partner is treated as not being a member of the partnership. Free income tax These transactions include the following. Free income tax 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. Free income tax 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. Free income tax Payments by accrual basis partnership to cash basis partner. Free income tax   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. Free income tax However, this rule does not apply to guaranteed payments made to a partner, which are generally deductible when accrued. Free income tax Guaranteed Payments Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. Free income tax 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. Free income tax This treatment is for purposes of determining gross income and deductible business expenses only. Free income tax For other tax purposes, guaranteed payments are treated as a partner's distributive share of ordinary income. Free income tax Guaranteed payments are not subject to income tax withholding. Free income tax The partnership generally deducts guaranteed payments on line 10 of Form 1065 as a business expense. Free income tax They are also listed on Schedules K and K-1 of the partnership return. Free income tax The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along with his or her distributive share of the partnership's other ordinary income. Free income tax Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. Free income tax Generally, organizational and syndication expenses are not deductible by the partnership. Free income tax 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). Free income tax Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on the partners' Schedule K-1 as guaranteed payments. Free income tax Minimum payment. Free income tax   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. Free income tax Example. Free income tax Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. Free income tax The partnership has net income of $20,000. Free income tax Divya's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). Free income tax The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). Free income tax 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. Free income tax If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard to the guarantee, would have been greater than the guarantee. Free income tax Self-employed health insurance premiums. Free income tax   Premiums for health insurance paid by a partnership on behalf of a partner, for services as a partner, are treated as guaranteed payments. Free income tax The partnership can deduct the payments as a business expense, and the partner must include them in gross income. Free income tax 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. Free income tax   A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf as an adjustment to income. Free income tax 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. Free income tax For more information on the self-employed health insurance deduction, see chapter 6 in Publication 535. Free income tax Including payments in partner's income. Free income tax   Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends. Free income tax Example 1. Free income tax 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. Free income tax Her distributive share of the partnership income is 10%. Free income tax The partnership has $50,000 of ordinary income after deducting the guaranteed payment. Free income tax 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. Free income tax Example 2. Free income tax Lamont is a calendar year taxpayer who is a partner in a partnership. Free income tax The partnership uses a fiscal year that ended January 31, 2013. Free income tax Lamont received guaranteed payments from the partnership from February 1, 2012, until December 31, 2012. Free income tax He must include these guaranteed payments in income for 2013 and report them on his 2013 income tax return. Free income tax Payments resulting in loss. Free income tax   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. Free income tax The partner separately takes into account his or her distributive share of the partnership loss, to the extent of the adjusted basis of the partner's partnership interest. Free income tax Sale or Exchange of Property Special rules apply to a sale or exchange of property between a partnership and certain persons. Free income tax Losses. Free income tax   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%. Free income tax   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. Free income tax   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. Free income tax   If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. Free income tax 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. Free income tax Gains. Free income tax   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. Free income tax More than 50% of the capital or profits interest in the partnership(s) is directly or indirectly owned by the same person(s). Free income tax The property in the hands of the transferee immediately after the transfer is not a capital asset. Free income tax 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. Free income tax More than 50% ownership. Free income tax   To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply. Free income tax 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. Free income tax An individual is considered to own the interest directly or indirectly owned by, or for, the individual's family. Free income tax For this rule, “family” includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants. Free income tax 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. Free income tax 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. Free income tax Example. Free income tax Individuals A and B and Trust T are equal partners in Partnership ABT. Free income tax A's husband, AH, is the sole beneficiary of Trust T. Free income tax Trust T's partnership interest will be attributed to AH only for the purpose of further attributing the interest to A. Free income tax As a result, A is a more-than-50% partner. Free income tax 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. Free income tax More information. Free income tax   For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Publication 544. Free income tax 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. Free income tax This applies whether a partnership is being formed or is already operating. Free income tax The partnership's holding period for the property includes the partner's holding period. Free income tax 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. Free income tax The exchange is not subject to the rules explained later under Disposition of Partner's Interest. Free income tax Disguised sales. Free income tax   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. Free income tax The distribution would not have been made but for the contribution. Free income tax The partner's right to the distribution does not depend on the success of partnership operations. Free income tax   All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized as a sale. Free income tax 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. Free income tax 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. Free income tax Form 8275 required. Free income tax   A partner must attach Form 8275, Disclosure Statement, (or other statement) to his or her 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. Free income tax For exceptions to this requirement, see section 1. Free income tax 707-3(c)(2) of the regulations. Free income tax   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. Free income tax   Form 8275 must include the following information. Free income tax A caption identifying the statement as a disclosure under section 707 of the Internal Revenue Code. Free income tax A description of the transferred property or money, including its value. Free income tax A description of any relevant facts in determining if the transfers are properly viewed as a disguised sale. Free income tax See section 1. Free income tax 707-3(b)(2) of the regulations for a description of the facts and circumstances considered in determining if the transfers are a disguised sale. Free income tax Contribution to partnership treated as investment company. Free income tax   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. Free income tax   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. Free income tax These items include money, stocks and other equity interests in a corporation, and interests in regulated investment companies and real estate investment trusts. Free income tax For more information, see section 351(e)(1) of the Internal Revenue Code and the related regulations. Free income tax Whether a partnership is treated as an investment company under this test is ordinarily determined immediately after the transfer of property. Free income tax   This rule applies to limited partnerships and general partnerships, regardless of whether they are privately formed or publicly syndicated. Free income tax Contribution to foreign partnership. Free income tax   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 if either of the following apply. Free income tax Immediately after the contribution, the partnership owned, directly or indirectly, at least a 10% interest in the foreign partnership. Free income tax The fair market value 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. Free income tax   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. Free income tax See the form instructions for more information. Free income tax Basis of contributed property. Free income tax   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. Free income tax Allocations to account for built-in gain or loss. Free income tax   The fair market value of property at the time it is contributed may be different from the partner's adjusted basis. Free income tax 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. Free income tax This rule also applies to contributions of accounts payable and other accrued but unpaid items of a cash basis partner. Free income tax   The partnership can use different allocation methods for different items of contributed property. Free income tax A single reasonable method must be consistently applied to each item, and the overall method or combination of methods must be reasonable. Free income tax See section 1. Free income tax 704-3 of the regulations for allocation methods generally considered reasonable. Free income tax   If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner. Free income tax 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. Free income tax 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. Free income tax Example. Free income tax Areta and Sofia formed an equal partnership. Free income tax Areta contributed $10,000 in cash to the partnership and Sofia contributed depreciable property with a fair market value of $10,000 and an adjusted basis of $4,000. Free income tax The partnership's basis for depreciation is limited to the adjusted basis of the property in Sofia's hands, $4,000. Free income tax In effect, Areta purchased an undivided one-half interest in the depreciable property with her contribution of $10,000. Free income tax 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 fair market value when contributed. Free income tax To simplify this example, the depreciation deductions are determined without regard to any first-year depreciation conventions. Free income tax However, since the partnership is allowed only $400 per year of depreciation (10% of $4,000), no more than $400 can be allocated between the partners. Free income tax The entire $400 must be allocated to Areta. Free income tax Distribution of contributed property to another partner. Free income tax   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. Free income tax   The recognized gain or loss is the amount the contributing partner would have recognized if the property had been sold for its fair market value when it was distributed. Free income tax This amount is the difference between the property's basis and its fair market value at the time of contribution. Free income tax 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. Free income tax 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. Free income tax Disposition of certain contributed property. Free income tax   The following rules determine the character of the partnership's gain or loss on a disposition of certain types of contributed property. Free income tax Unrealized receivables. Free income tax 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. Free income tax Unrealized receivables are defined later under Payments for Unrealized Receivables and Inventory Items. Free income tax When reading the definition, substitute “partner” for “partnership. Free income tax ” Inventory items. Free income tax 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. Free income tax Inventory items are defined later in Payments for Unrealized Receivables and Inventory Items. Free income tax Capital loss property. Free income tax 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. Free income tax The capital loss is limited to the amount by which the partner's adjusted basis for the property exceeded the property's fair market value immediately before the contribution. Free income tax Substituted basis property. Free income tax 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. Free income tax Contribution of Services A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed. Free income tax Capital interest. Free income tax   A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership. Free income tax This determination generally is made at the time of receipt of the partnership interest. Free income tax The fair market value 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. Free income tax The capital interest transferred as compensation for services is subject to the rules for restricted property discussed in Publication 525 under Employee Compensation. Free income tax   The fair market value of an interest in partnership capital transferred to a partner as payment for services to the partnership is a guaranteed payment, discussed earlier. Free income tax Profits interest. Free income tax   A profits interest is a partnership interest other than a capital interest. Free income tax 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. Free income tax However, this does not apply in the following situations. Free income tax 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. Free income tax Within 2 years of receipt, the partner disposes of the profits interest. Free income tax The profits interest is a limited partnership interest in a publicly traded partnership. Free income tax   A profits interest transferred as compensation for services is not subject to the rules for restricted property that apply to capital interests. Free income tax Basis of Partner's Interest The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. Free income tax If the partner must recognize gain as a result of the contribution, this gain is included in the basis of his or her interest. Free income tax 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. Free income tax Interest acquired by gift, etc. Free income tax   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 Publication 551. Free income tax Adjusted Basis There is a worksheet for adjusting the basis of a partner's interest in the partnership in the Partner's Instructions for Schedule K-1 (Form 1065). Free income tax The basis of an interest in a partnership is increased or decreased by certain items. Free income tax Increases. Free income tax   A partner's basis is increased by the following items. Free income tax The partner's additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities. Free income tax The partner's distributive share of taxable and nontaxable partnership income. Free income tax 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. Free income tax Decreases. Free income tax   The partner's basis is decreased (but never below zero) by the following items. Free income tax 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. Free income tax The partner's distributive share of the partnership losses (including capital losses). Free income tax The partner's distributive share of nondeductible partnership expenses that are not capital expenditures. Free income tax This includes the partner's share of any section 179 expenses, even if the partner cannot deduct the entire amount on his or her individual income tax return. Free income tax 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. Free income tax Partner's liabilities assumed by partnership. Free income tax   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. Free income tax This partner must reduce his or her basis because the assumption of the liability is treated as a distribution of money to that partner. Free income tax The other partners' assumption of the liability is treated as a contribution by them of money to the partnership. Free income tax See Effect of Partnership Liabilities , later. Free income tax Example 1. Free income tax 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. Free income tax The partnership assumed payment of the mortgage. Free income tax The basis of Ivan's interest is: Adjusted basis of contributed property $8,000 Minus: Part of mortgage assumed by other partners (80% × $4,000) 3,200 Basis of Ivan's partnership interest $4,800 Example 2. Free income tax If, in Example 1, the contributed property had a $12,000 mortgage, the basis of Ivan's partnership interest would be zero. Free income tax 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. Free income tax However, this gain would not increase the basis of his partnership interest. Free income tax Book value of partner's interest. Free income tax   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. Free income tax Example. Free income tax Enzo contributes to his partnership property that has an adjusted basis of $400 and a fair market value of $1,000. Free income tax His partner contributes $1,000 cash. Free income tax While each partner has increased his capital account by $1,000, which will be re
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The Free Income Tax

Free income tax 5. Free income tax   Credits Table of Contents Credit for the Elderly or the DisabledCan You Take the Credit? Figuring the Credit Child and Dependent Care Credit Earned Income Credit (EIC)Do You Qualify for the Earned Income Credit (EIC)? Figuring the EIC This chapter briefly discusses the credit for the elderly or disabled, the child and dependent care credit, and the earned income credit. Free income tax You may be able to reduce your federal income tax by claiming one or more of these credits. Free income tax Credit for the Elderly or the Disabled This section explains who qualifies for the credit for the elderly or the disabled and how to figure this credit. Free income tax For more information, see Publication 524, Credit for the Elderly or the Disabled. Free income tax You can take the credit only if you file Form 1040 or Form 1040A. Free income tax You cannot take the credit if you file Form 1040EZ or Form 1040NR. Free income tax Can You Take the Credit? You can take the credit for the elderly or the disabled if you meet both of the following requirements. Free income tax You are a qualified individual. Free income tax Your income is not more than certain limits. Free income tax  You can use Figure 5-A and Figure 5-B as guides to see if you are eligible for the credit. Free income tax   Qualified Individual You are a qualified individual for this credit if you are a U. Free income tax S. Free income tax citizen or resident alien, and either of the following applies. Free income tax You were age 65 or older at the end of 2013. Free income tax You were under age 65 at the end of 2013 and all three of the following statements are true. Free income tax You retired on permanent and total disability (explained later). Free income tax You received taxable disability income for 2013. Free income tax On January 1, 2013, you had not reached mandatory retirement age (defined later under Disability income ). Free income tax Age 65. Free income tax You are considered to be age 65 on the day before your 65th birthday. Free income tax Therefore, you are considered to be age 65 at the end of 2013 if you were born before January 2, 1949. Free income tax Figure 5-A. Free income tax Are You a Qualified Individual? This image is too large to be displayed in the current screen. Free income tax Please click the link to view the image. Free income tax Figure 5-A, Are you a qualified individual? U. Free income tax S. Free income tax citizen or resident alien. Free income tax   You must be a U. Free income tax S. Free income tax citizen or resident alien (or be treated as a resident alien) to take the credit. Free income tax Generally, you cannot take the credit if you were a nonresident alien at any time during the tax year. Free income tax Exceptions. Free income tax   You may be able to take the credit if you are a nonresident alien who is married to a U. Free income tax S. Free income tax citizen or resident alien at the end of the tax year and you and your spouse choose to treat you as a U. Free income tax S. Free income tax resident alien. Free income tax If you make that choice, both you and your spouse are taxed on your worldwide income. Free income tax   If you were a nonresident alien at the beginning of the year and a resident alien at the end of the year, and you were married to a U. Free income tax S. Free income tax citizen or resident alien at the end of the year, you may be able to choose to be treated as a U. Free income tax S. Free income tax resident alien for the entire year. Free income tax In that case, you may be allowed to take the credit. Free income tax   For information on these choices, see chapter 1 of Publication 519, U. Free income tax S. Free income tax Tax Guide for Aliens. Free income tax Married persons. Free income tax   Generally, if you are married at the end of the tax year, you and your spouse must file a joint return to take the credit. Free income tax However, if you and your spouse did not live in the same household at any time during the tax year, you can file either a joint return or separate returns and still take the credit. Free income tax Head of household. Free income tax   You can file as head of household and qualify to take the credit even if your spouse lived with you during the first 6 months of the year if you meet certain tests. Free income tax See Publication 524 and Publication 501. Free income tax Under age 65. Free income tax   If you are under age 65 at the end of 2013, you can qualify for the credit only if you are retired on permanent and total disability and have taxable disability income (discussed later under Disability income ). Free income tax You are considered to be under age 65 at the end of 2013 if you were born after January 1, 1949. Free income tax You are retired on permanent and total disability if: You were permanently and totally disabled when you retired, and You retired on disability before the end of the tax year. Free income tax   Even if you do not retire formally, you may be considered retired on disability when you have stopped working because of your disability. Free income tax If you retired on disability before 1977 and were not permanently and totally disabled at the time, you can qualify for the credit if you were permanently and totally disabled on January 1, 1976, or January 1, 1977. Free income tax Permanent and total disability. Free income tax   You are permanently and totally disabled if you cannot engage in any substantial gainful activity because of your physical or mental condition. Free income tax A physician must certify that the condition has lasted or can be expected to last continuously for 12 months or more, or that the condition can be expected to result in death. Free income tax See Physician's statement , later. Free income tax Substantial gainful activity. Free income tax   Substantial gainful activity is the performance of significant duties over a reasonable period of time while working for pay or profit, or in work generally done for pay or profit. Free income tax   Full-time work (or part-time work done at the employer's convenience) in a competitive work situation for at least the minimum wage conclusively shows that you are able to engage in substantial gainful activity. Free income tax   Substantial gainful activity is not work you do to take care of yourself or your home. Free income tax It is not unpaid work on hobbies, institutional therapy or training, school attendance, clubs, social programs, and similar activities. Free income tax However, doing this kind of work may show that you are able to engage in substantial gainful activity. Free income tax    Figure 5-B. Free income tax Income Limits IF your filing status is. Free income tax . Free income tax . Free income tax THEN even if you qualify (see Figure 5-A), you CANNOT take the credit if: Your adjusted gross income (AGI)* is equal to or more than. Free income tax . Free income tax . Free income tax OR the total of your nontaxable social security and other nontaxable pension(s), annuities, or disability income is equal to or more than. Free income tax . Free income tax . Free income tax single, head of household, or qualifying widow(er) with dependent child $17,500 $5,000 married filing jointly and only one spouse qualifies in Figure 5-A $20,000 $5,000 married filing jointly and both spouses qualify in Figure 5-A $25,000 $7,500 married filing separately and you lived apart from your spouse for all of 2013 $12,500 $3,750 *AGI is the amount on Form 1040A, line 22, or Form 1040, line 38      The fact that you have not worked for some time is not, of itself, conclusive evidence that you cannot engage in substantial gainful activity. Free income tax Physician's statement. Free income tax   If you are under age 65, you must have your physician complete a statement certifying that you were permanently and totally disabled on the date you retired. Free income tax   You do not have to file this statement with your tax return, but you must keep it for your records. Free income tax The Instructions for Schedule R (Form 1040A or 1040) include a statement your physician can complete and that you can keep for your records. Free income tax Veterans. Free income tax   If the Department of Veterans Affairs (VA) certifies that you are permanently and totally disabled, you can substitute VA Form 21-0172, Certification of Permanent and Total Disability, for the physician's statement you are required to keep. Free income tax VA Form 21-0172 must be signed by a person authorized by the VA to do so. Free income tax You can get this form from your local VA regional office. Free income tax Physician's statement obtained in earlier year. Free income tax   If you got a physician's statement in an earlier year and, due to your continued disabled condition, you were unable to engage in any substantial gainful activity during 2013, you may not need to get another physician's statement for 2013. Free income tax For a detailed explanation of the conditions you must meet, see the instructions for Schedule R (Form 1040A or 1040), Part II. Free income tax If you meet the required conditions, you must check the box on Schedule R (Form 1040A or 1040), Part II, line 2. Free income tax   If you checked Schedule R (Form 1040A or 1040), Part I, box 4, 5, or 6, print in the space above the box in Part II, line 2, the first name(s) of the spouse(s) for whom the box is checked. Free income tax Disability income. Free income tax   If you are under age 65, you must also have taxable disability income to qualify for the credit. Free income tax   Disability income must meet the following two requirements. Free income tax It must be paid under your employer's accident or health plan or pension plan. Free income tax It must be included in your income as wages (or payments in lieu of wages) for the time you are absent from work because of permanent and total disability. Free income tax Payments that are not disability income. Free income tax   Any payment you receive from a plan that does not provide for disability retirement is not disability income. Free income tax Any lump-sum payment for accrued annual leave that you receive when you retire on disability is a salary payment and is not disability income. Free income tax   For purposes of the credit for the elderly or the disabled, disability income does not include amounts you receive after you reach mandatory retirement age. Free income tax Mandatory retirement age is the age set by your employer at which you would have had to retire had you not become disabled. Free income tax Figuring the Credit You can figure the credit yourself, or the IRS will figure it for you. Free income tax Figuring the credit yourself. Free income tax   If you figure the credit yourself, fill out the front of Schedule R (Form 1040A or 1040). Free income tax Next, fill out Schedule R (Form 1040A or 1040), Part III. Free income tax Credit figured for you. Free income tax   If you can take the credit and you want the IRS to figure the credit for you, see Publication 524 or the Instructions for Schedule R (Form 1040A or 1040). Free income tax If you want the IRS to figure your tax, see chapter 30 of Publication 17, Your Federal Income Tax. Free income tax Child and Dependent Care Credit You may be able to claim this credit if you pay someone to care for your dependent who is under age 13 or for your spouse or dependent who is not able to care for himself or herself. Free income tax The credit can be up to 35% of your expenses. Free income tax To qualify, you must pay these expenses so you can work or look for work. Free income tax If you claim this credit, you must include on your return the name and taxpayer identification number (generally the social security number) of each qualifying person for whom care is provided. Free income tax If the correct information is not shown, the credit may be reduced or disallowed. Free income tax You also must show on your return the name, address, and the taxpayer identification number of the person(s) or organization(s) that provided the care. Free income tax For more information, see Publication 503, Child and Dependent Care Expenses. Free income tax Earned Income Credit (EIC) The earned income credit (EIC) is a refundable tax credit for certain people who work and have earned income under $51,567. Free income tax The EIC is available to persons with or without a qualifying child. Free income tax Credit has no effect on certain welfare benefits. Free income tax   Any refund you receive because of the EIC cannot be counted as income when determining whether you or anyone else is eligible for benefits or assistance, or how much you or anyone else can receive, under any federal program or under any state or local program financed in whole or in part with federal funds. Free income tax These programs include the following. Free income tax Medicaid and supplemental security income (SSI). Free income tax Supplemental Nutrition Assistance Program (food stamps). Free income tax Low-income housing. Free income tax Temporary Assistance for Needy Families (TANF). Free income tax  In addition, when determining eligibility, the refund cannot be counted as a resource for at least 12 months after you receive it. Free income tax Check with your local benefit coordinator to find out if your refund will affect your benefits. Free income tax Do You Qualify for the Earned Income Credit (EIC)? Use Table 5-1 as an initial guide to the rules you must meet in order to qualify for the EIC. Free income tax The specific rules you must meet depend on whether you have a qualifying child. Free income tax If you have a qualifying child, the rules in Parts A, B, and D apply to you. Free income tax If you do not have a qualifying child, the rules in Parts A, C, and D apply to you. Free income tax  If, after reading all the rules in each part that applies to you, you think you may qualify for the credit, see Publication 596, Earned Income Credit, for more details about the EIC. Free income tax You can also find information about the EIC in the instructions for Form 1040 (line 64a), Form 1040A (line 38a), or Form 1040EZ (line 8a). Free income tax The sections that follow provide additional information for some of the rules. Free income tax Adjusted gross income (AGI). Free income tax   Under Rule 1, you cannot claim the EIC unless your AGI is less than the applicable limit shown in Part A of Table 5-1. Free income tax Your AGI is the amount on line 37 (Form 1040), line 21 (Form 1040A), or line 4 (Form 1040EZ). Free income tax Table 5-1. Free income tax Earned Income Credit (EIC) in a Nutshell First, you must meet all the rules in this column. Free income tax Second, you must meet all the rules in one of these columns, whichever applies. Free income tax Third, you must meet the rule in this column. Free income tax Part A. Free income tax  Rules for Everyone Part B. Free income tax  Rules If You Have a Qualifying Child Part C. Free income tax  Rules If You Do Not Have a Qualifying Child Part D. Free income tax  Figuring and Claiming the EIC 1. Free income tax Your adjusted gross income (AGI) must be less than: •$46,227 ($51,567 for married filing jointly) if you have three or more qualifying children, •$43,038 ($48,378 for married filing jointly) if you have two qualifying children, •$37,870 ($43,210 for married filing jointly) if you have one qualifying child, or  •$14,340 ($19,680 for married filing jointly) if you do not have a qualifying child. Free income tax 2. Free income tax You must have a valid social security number. Free income tax  3. Free income tax Your filing status cannot be “Married filing separately. Free income tax ” 4. Free income tax You must be a U. Free income tax S. Free income tax citizen or resident alien all year. Free income tax  5. Free income tax You cannot file Form 2555 or Form 2555-EZ (relating to foreign earned income). Free income tax  6. Free income tax Your investment income must be $3,300 or less. Free income tax  7. Free income tax You must have earned income. Free income tax 8. Free income tax Your child must meet the relationship, age, residency, and joint return tests. Free income tax  9. Free income tax Your qualifying child cannot be used by more than one person to claim the EIC. Free income tax  10. Free income tax You generally cannot be a qualifying child of another person. Free income tax 11. Free income tax You must be at least age 25 but under age 65. Free income tax  12. Free income tax You cannot be the dependent of another person. Free income tax  13. Free income tax You generally cannot be a qualifying child of another person. Free income tax  14. Free income tax You must have lived in the United States more than half of the year. Free income tax 15. Free income tax Your earned income must be less than: •$46,227 ($51,567 for married filing jointly) if you have three or more qualifying children, •$43,038 ($48,378 for married filing jointly) if you have two qualifying children, •$37,870 ($43,210 for married filing jointly) if you have one qualifying child, or •$14,340 ($19,680 for married filing jointly) if you do not have a qualifying child. Free income tax Social security number. Free income tax   Under Rule 2, you (and your spouse if you are married filing jointly) must have a valid social security number (SSN) issued by the Social Security Administration (SSA). Free income tax Any qualifying child listed on Schedule EIC also must have a valid SSN. Free income tax (See Qualifying child , later, if you have a qualifying child. Free income tax )   If your social security card (or your spouse's if you are married filing jointly) says “Not valid for employment” and your SSN was issued so that you (or your spouse) could get a federally funded benefit, you cannot get the EIC. Free income tax An example of a federally funded benefit is Medicaid. Free income tax Investment income. Free income tax   Under Rule 6, you cannot claim the EIC unless your investment income is $3,300 or less. Free income tax If your investment income is more than $3,300, you cannot claim the credit. Free income tax For most people, investment income is the total of the following amounts. Free income tax Taxable interest (line 8a of Form 1040 or 1040A). Free income tax Tax-exempt interest (line 8b of Form 1040 or 1040A). Free income tax Dividend income (line 9a of Form 1040 or 1040A). Free income tax Capital gain net income (line 13 of Form 1040, if more than zero, or line 10 of Form 1040A). Free income tax  If you file Form 1040EZ, your investment income is the total of the amount of line 2 and the amount of any tax-exempt interest you wrote to the right of the words “Form 1040EZ” on line 2. Free income tax   For more information about investment income, see Publication 596, Earned Income Credit. Free income tax Earned income. Free income tax   Under Rule 7, you must have earned income to claim the EIC. Free income tax Under Rule 15, you cannot claim the EIC unless your earned income is less than the applicable limit shown in Table 5-1, Part D. Free income tax Earned income includes all of the following types of income. Free income tax Wages, salaries, tips, and other taxable employee pay. Free income tax Employee pay is earned income only if it is taxable. Free income tax Nontaxable employee pay, such as certain dependent care benefits and adoption benefits, is not earned income. Free income tax But there is an exception for nontaxable combat pay, which you can choose to include in earned income. Free income tax Net earnings from self-employment. Free income tax Gross income received as a statutory employee. Free income tax Gross income defined. Free income tax   Gross income means all income you received in the form of money, goods, property, and services that is not exempt from tax, including any income from sources outside the United States or from the sale of your main home (even if you can exclude part or all of it). Free income tax Do not include any social security benefits unless (a) you are married filing a separate tax return and you lived with your spouse at any time in 2013, or (b) one-half of your social security benefits plus your other gross income and any tax-exempt interest is more than $25,000 ($32,000 if married filing jointly). Free income tax If (a) or (b) applies, see the instructions for Form 1040, lines 20a and 20b to figure the taxable part of social security benefits you must include in gross income. Free income tax Self-employed persons. Free income tax   If you are self-employed and your net earnings are $400 or more, be sure to correctly fill out Schedule SE (Form 1040), Self-Employment Tax, and pay the proper amount of self-employment tax. Free income tax If you do not, you may not get all the credit to which you are entitled. Free income tax Disability benefits. Free income tax   If you retired on disability, taxable benefits you receive under your employer's disability retirement plan are considered earned income until you reach minimum retirement age. Free income tax Minimum retirement age generally is the earliest age at which you could have received a pension or annuity if you were not disabled. Free income tax Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension and are not considered earned income. Free income tax   Payments you received from a disability insurance policy that you paid the premiums for are not earned income. Free income tax It does not matter whether you have reached minimum retirement age. Free income tax If this policy is through your employer, the amount may be shown in box 12 of your Form W-2 with code J. Free income tax Income that is not earned income. Free income tax   Examples of items that are not earned income under Rule 7 include interest and dividends, pensions and annuities, social security and railroad retirement benefits (including disability benefits — except for payments covered under Disability benefits earlier), alimony and child support, welfare benefits, workers' compensation benefits, unemployment compensation (insurance), nontaxable foster care payments, and veterans' benefits, including VA rehabilitation payments. Free income tax Do not include any of these items in your earned income. Free income tax Workfare payments. Free income tax   Nontaxable workfare payments are not earned income for the EIC. Free income tax These are cash payments certain people receive from a state or local agency that administers public assistance programs funded under the federal Temporary Assistance for Needy Families (TANF) program in return for certain work activities such as (1) work experience activities (including remodeling or repairing public housing) if sufficient private sector employment is not available, or (2) community service program activities. Free income tax Qualifying child. Free income tax   Under Rule 8, your child is a qualifying child if your child meets four tests. Free income tax The four tests are: Relationship, Age, Residency, and Joint return. Free income tax   The four tests are illustrated in Figure 5-C. Free income tax See Publication 596 for more information about each test. Free income tax Figure 5-C. Free income tax Tests for Qualifying Child A qualifying child for the EIC is a child who is your. Free income tax . Free income tax . Free income tax Son, daughter, stepchild, foster child,  or a descendant of any of them (for example, your grandchild) OR Brother, sister, half brother, half sister, stepbrother,  stepsister, or a descendant of any of them (for example, your  niece or nephew) was . Free income tax . Free income tax . Free income tax Under age 19 at the end of 2013 and younger than you (or your spouse if filing jointly) OR Under age 24 at the end of 2013, a student, and younger than you (or your spouse if filing jointly) OR Permanently and totally disabled at any time during the year, regardless of age who. Free income tax . Free income tax . Free income tax Is not filing a joint return for 2013  (or is filing a joint return for 2013 only as a claim for refund of income tax withheld or estimated tax paid) who. Free income tax . Free income tax . Free income tax Lived with you in the United States for more than half of 2013. Free income tax  If the child did not live with you for the required time, see Publication 596 for more information. Free income tax Figuring the EIC To figure the amount of your credit, you have two choices. Free income tax Have the IRS figure the EIC for you. Free income tax If you want to do this, see IRS Will Figure the EIC for You in Publication 596. Free income tax Figure the EIC yourself. Free income tax If you want to do this, see How To Figure the EIC Yourself in Publication 596. Free income tax Prev  Up  Next   Home   More Online Publications