Partnership Formation and Partners Interest In the Partnership

Like the formation of a corporation, initial contributions to a partnership are a tax deferred event.  Section 721(a) of the code states, “No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.”  The policy reason behind this is very simple and straightforward: by not taxing the formation of a new company, the code is encouraging people to form partnerships in the hopes this will increase economic activity.

This event is tax deferred because the basis of the contributed property carries over to the partnership.  Section 723 states, “The basis of property contributed to a partnership by a partner shall be the adjusted basis of such property to the contributing partner at the time of the contribution.”  The contributing partner receives the same basis in his partnership interest, as stated in section 722(a): “The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution.”  By carrying over the basis, the code preserves the gain inherent in the property, and allows the recognition of that gain to only occur when the partnership sells the property.

Central to the idea of a partnership is an agreement to share the benefits and burdens of business ownership.  Treasury Regulation 1.704-1(b)(3)(i) states, “the partners interest in the partnership signifies … the manner in which the partners have agreed to share the economic benefit or burden … corresponding to the income, gain, loss, deduction or credit that is allocated.”  But to share in the benefits and burdens, the partners need to know their respective ownership percentages.  This is almost always spelled out in the partnership agreement.  However, in the event there is no agreement, the following factors are considered (Treas. Reg. 1.704-1(b)(3)(ii)(a)-(d)).

The partner’s contributions: if two people form a partnership, and each contributes $50, it’s a good bet that they each think they are 50/50 partners.

The interest of the partners in economic profits and losses:  not only are profits distributed from a business in the form of money, but numerous other accounting benefits also accrue.  Continuing the 50/50 example above, suppose the two partners agree to distribute depreciation in a 90%/10% allocation.  This would be an indication the partners intended to distribute this balance sheet item differently

The interest of the partners in cash flow and other non-liquidating distributions: the manner and proportions in which the partnership distributes cash is solid prima facie evidence of the parties distributive intend.

The rights of the partners to distributions of capital on liquidation: the final split of the partnership is a good final indicator.

Again, remember these terms and conditions are almost always contained in the partnership agreement, making the above factors unnecessary.  However, it’s good to have them as a back-up just in case.