By Nick Eusanio & Jared Boswell

A partnership is one of the most common business structures in the United States because it provides strong flexibility to investors and operators. But that flexibility comes with technical rules that can create unexpected tax outcomes if not structured carefully. This article is the first in our Partnership Tax Basics series, focused on the partnership classification for tax purposes.  Below is an overview of the versatility and governing fundamental U.S. federal income tax principles associated with initial investment in, and operation of, partnerships.

TL; DR Highlights

• Partnerships are commercially flexible and customizable for investors and operators.
• Tax is generally paid once—at the partner level.
• Most contributions are tax-deferred, but exceptions can trigger immediate tax.
• Liability allocation can directly impact each partner’s tax basis and deductions.
• Contributions of built-in gain property require special tracking and allocation.

Flexbility of the Partnership Form

A key advantage to the partnership form is the flexibility it affords the parties in structuring the arrangement. Subject to certain tax and legal guardrails, some of these points of flexibility include: investor/partner type (individual or legal entity), contribution type (cash, property, services and minority vs. controlling) and impact (nonrecognition), profit and loss allocations, distributions (timing, type), single level of taxation (partner level only), and exit strategies.

What is a Partnership for Tax Purposes? Entity Classification (Default Rules & Check-the-Box Election)

For tax purposes, a partnership is a flow-through entity. The partnership itself does not pay federal income tax. Instead, income, deductions, and credits flow through to the partners (via reporting on Schedule K-1), who report them on their individual returns.

Generally, if an unincorporated U.S. business entity (i.e., a limited liability company (LLC) or state law partnership) has more than one owner, it is automatically classified as a partnership for federal income tax purposes under the default classification rules of Treas. Reg. § 301.7701-3(b)(1). This is true also for a venture between multiple parties even if the parties have not formed a legal entity to carry on the business. But the owners of an unincorporated U.S. business entity can elect a different classification (e.g., corporation) under Treas. Reg. 301.7701-3(c) than the default by filing Form 8832 with the IRS. The rules governing non-U.S. entities, as well as other available elections (e.g., S corporation status via Form 2553) are beyond the scope of this article.

Section 721(a) – General Nonrecognition Rule

Section 721(a) generally provides that no gain or loss is recognized to a partnership or any of its partners on contribution of property to the partnership in exchange for an interest in the partnership. For example, assume Partner A contributes $1 million and Partner B contributes $10 million to a partnership, and each receives a 50% interest in the partnership. There is an economic mismatch because each partner receives a 50% interest while contributing significantly different amounts of capital. Despite this economic disparity,  Section 721(a) generally dictates that no gain or loss is recognized to the partners or the partnership on this transaction, because cash (property) was exchanged for partnership interests. This flexibility allows investors to negotiate economics freely without triggering immediate tax—even where ownership percentages and capital contributions don’t align. That said, other partnership tax rules (such as those governing maintenance of capital accounts for each partner) operate to align the ultimate economic and tax impacts of such an arrangement.

As another point of versatility, Section 721(a) is by its terms more accessible to investors than similar tax-deferred contribution provisions found elsewhere in the Code. For example, Section 351 is an analogous nonrecognition provision in the corporate context. Section 351 generally requires that a transferor (or group of transferors) of property to a corporation have 80% or more of the ownership of the corporation immediately after contribution to qualify for nonrecognition. Section 721(a) is much more permissive because there is no such control requirement for contributors to a partnership. This framework allows multiple investors to contribute property to a partnership in exchange for a partnership interest on a tax-deferred basis, regardless of the resulting ownership structure. This mechanic facilitates unrelated minority investor contributions without immediate tax impact.

Exceptions to Section 721(a)

Although the general rule of Section 721(a) is nonrecognition, the facts and mechanics of partnership formation and operation can create potential tax issues without careful attention to detail and planning.

• Definitional Exception – Exchange of Partnership Interest for Services

The general nonrecognition rule of Section 721(a) does not apply to the receipt of a partnership interest in exchange for services, because services are not property. Under Section 83(a) and Treas. Reg. § 1.721-1(b)(1) such a “sweat-equity” arrangement may give rise to ordinary income to the partner at the time the partnership interest is issued. This depends on whether the partnership interest received constitutes a capital interest (taxable as ordinary income / compensation at the time of issuance per Treas. Reg. § 1.721-1(b)(1)) or a profits interest (to which Rev. Procs. 93-27 and 2001-43 and / or a protective Section 83(b) election apply, not taxable at the time of issuance and potential long-term capital gain treatment on subsequent sale of the interest). Stay tuned for more in a future article on this complex topic.

• Investment Company Exception – Section 721(b):

Section 721(b) provides that the general nonrecognition rule doesn’t apply to a transfer of property to a partnership which would be treated as an investment company within the meaning of Section 351(e), (i.e., a company holding as assets stocks and securities making up 80% of the value of its total assets). In that case, application of Section 721(b) triggers recognition of gain on contribution of the property.

• Appreciated Property & Related Foreign Partners Exception – Section 721(c):

Section 721(c) may require immediate gain recognition in certain situations where a U.S. transferor contributes appreciated property (i.e., property with a FMV exceeding its basis) to a partnership that includes related non-U.S. partners. The Gain Deferral Method rules (Treas. Reg. § 1.721(c)(3)), if properly followed, can permit the U.S. transferor to defer recognition of such built-in gain over time rather than recognizing it immediately in such a scenario. These rules are intended to prevent the shifting of built-in gain outside the U.S. tax system.

• Disguised Sales – Section 707(a) & Treas. Reg. § 1.707-3:

The “disguised sale” rules of Section 707(a) and Treas. Reg. § 1.707-3 can also override the general nonrecognition rule of Section 721(a). If a partner transfers property to a partnership and receives cash or other consideration from the partnership in a related transaction, the transaction may be treated as a disguised sale and trigger gain recognition to the partner. Under Treas. Reg. § 1.707-3(c), a transfer occurring within two years of the contribution is presumed to be a sale unless facts and circumstances clearly establish otherwise. But transfers after two years are presumed not to be a disguised sale under Treas. Reg. § 1.707-3(d). So, a transaction whereby Partner A and Partner B are entering the partnership to transfer cash from Partner B to Partner A, is expected be categorized as a disguised sale.

Partner Basis and Liabilities (Section 722 & Section 752)

Basis is important in determining the amount of gain or loss, if any, on a taxable disposition of a partnership interest (outside basis) or partnership assets/property (inside basis).

• Outside Basis

If a contribution satisfies Section 721(a), the partner is expected to have outside basis consistent with the contribution’s adjusted basis at the time of the contribution under Section 722. Such basis is increased by any gain recognized under Section  721(b) to the contributing partner at the time of contribution, and by the amount of partnership recourse liability assumed by the partner.  In our continuing example, Partner A would have $1 million of outside basis and Partner B would have $10 million outside basis (i.e., basis in their respective partnership interests) on contribution. To the extent Partner A and Partner B are subject to partnership liabilities (such as loans), each partner’s outside basis is increased by the partner’s relative share of such liabilities under Section 752 (assuming the liabilities are recourse liabilities for which the partner assumes the economic risk of loss under Treas. Reg. § 1.752-2).

Whether a liability is recourse or nonrecourse affects how it is allocated for a partnership tax purposes. A recourse liability is allocated to the partner who bears the economic risk of loss with respect to the liability. A nonrecourse liability is allocated among the partners based on their respective shares of partnership minimum gain and Section 704(c) gain, with any residual according to their profit-sharing ratios under Treas. Reg. § 1.752-3.

• Inside Basis

Under Section 723, the inside basis of a partnership asset is the adjusted basis of such asset to the contributing partner at the time of the contribution, increased by the amount of any gain recognized under Section 721(b) to the contributing partner at that time.

Capital Accounts – Section 704(b) and Treas. Reg. § 1.704-1(b)(2)(iv)

Maintenance of capital accounts for partners is an important requirement set forth in Section 704(b) and Treas. Reg. § 1.704-1(b)(2)(iv). Capital accounts track a partner’s net equity in a partnership and are used to support tax allocations and determine economic rights and tax impacts of distributions, transactions and liquidation. A partner’s initial capital account balance generally matches the partner’s initial contribution. Thereafter, certain adjustments are made to the capital account balance of each partner based on future contributions, allocations of income, loss and deduction, distributions, and other items of the partner or partnership as set forth in the regulations. The rules governing maintenance of capital accounts are complex and beyond the scope of this article. But, generally, these rules aim to ensure that any allocation of income, gain, loss, deduction or other partnership item to a partner has substantial economic effect (loosely meaning that the tax impacts of the allocation align to the economic reality of the arrangement).

Built-In Gain Property and Section 704(c)

The type of property contributed to a partnership can have special impacts to the relevant partner capital accounts. For example, contribution of real property can create differences in the book value versus the tax value of capital accounts (i.e., a book-tax disparity). Adjusting our prior example, assume Partner A contributes $1 million in cash, but Partner B now contributes real property worth $10 million (having an adjusted basis of $5 million) to the partnership, each in exchange for a 50% partnership interest. The general nonrecognition rule still applies, such that no gain or loss is recognized on these contributions. But Partner B’s contribution of real estate having a $10 million FMV and $5 million adjusted basis (i.e., a book-tax disparity from appreciated property) creates built-in gain subject to Section 704(c). This built-in gain is attributable to Partner B and is reduced over time through book and tax depreciation differences. Notably, attribution of the Section 704(c) layer may differ based on the allocation method chosen by the partners in the partnership/operating agreement. Common methods include the traditional method, traditional with curative method, or remedial method. Each method has advantages and disadvantages, which are beyond the scope of this article and should be discussed with a tax professional before deciding which method is appropriate.

Special Deductions: Section 199A for Qualified Business Income

In addition to various points of flexibility, the partnership form now offers the potential to access the special tax deduction set forth in Section 199A. Section 199A was implemented in 2017, as part of the Tax Cuts and Jobs Act (TCJA), to better align effective tax rates of the pass-through business forms (like partnerships) with those of the corporate form (21% since TCJA). The Section 199A deduction is available for eligible partners of domestic partnerships for tax years beginning after December 31, 2017. Section 199A permits individuals, trusts and estates with pass-through business income to deduct up to 20% of qualified business income (QBI) from their taxable income. Importantly, eligibility for the Section 199A deduction is subject to various limitations beyond the scope of this article and should be evaluated with a tax professional.

Closing

The tax-deferred nature of a partnership formation is advantageous to investors and allows broad flexibility in the amount and type of capital contributed, number and type of investors, and the terms governing the partners’ economic arrangement and the partnership’s operations. Legislative changes like Section 199A aimed at achieving partnership to corporate tax rate parity have also improved the economics of the partnership business form. As a result, the partnership tax classification is used frequently by private equity groups investing in operating companies and joint ventures, real estate investors developing their portfolios, and by local entrepreneurs pursuing business ventures. Structural and economic versatility make the partnership tax classification an attractive choice for a diverse investor base.

Coming Next

Partnership Tax Basics, Part 2: Sale of a Partnership Interest: In our next article, we’ll examine the tax consequences of sale of a partnership interest to both the partnership and the partners.

Connect with Nick Eusanio, Tax Planning & Compliance Partner at DBL Law and Jared Boswell, Tax Planning & Compliance Associate at DBL Law, to learn how proper investment or transaction structure and tax planning can help you achieve the desired outcome.