Figures: tax year 2026
A preparer must calculate tax implications from the agreement, the partner's capacity, and the consideration transferred. Compensation, property contributions, sales, and ownership distributions follow different recognition and basis rules.
- Outside basis is the partner's adjusted tax basis in the partnership interest, including the applicable share of partnership liabilities.
- Inside basis is the partnership's adjusted tax basis in a particular asset. A capital account or fair market value cannot substitute for either tax basis.
- Realized gain or loss measures the difference produced by a disposition before applying recognition restrictions.
- Recognized gain or loss is the amount taken into account currently under the applicable tax rules.
Services performed by a partner for tax purposes require classification before income is allocated. A bona fide partner is self-employed with respect to the partnership, even when an agreement describes compensation as a salary.
To calculate tax implications, the partnership first deducts any currently deductible guaranteed payment from income before allocating the remaining distributive shares. The recipient reports both the guaranteed payment and the resulting share.
Common mistakes
- Allocating profit before compensation. In Example 1, overstates Nora's income by $6,000.
- Using grant value without election. Example 4's $20,000 grant value does not replace the $30,000 vesting value when the award remains substantially nonvested.
- Increasing inside basis for debt gain. Example 8's incorrect land basis adds partner-level debt-relief gain to carryover basis: .
Bottom line
- Partner capacity and payment terms determine whether a transaction is compensation, an income allocation, a sale, or an ownership distribution.
- Vested capital interests create compensation income; nonvested capital interests generally defer inclusion unless a timely early election applies, while qualifying profits interests receive separate safe-harbor protection.
- Ordinary property contributions preserve inside basis and defer built-in gain or loss; excess net liability relief can independently create partner-level gain.
- Nonliquidating property distributions use carryover basis capped by remaining outside basis and permit no ordinary distribution loss.
Exam shortcut
Mark the agreement first: fixed service amount, income-dependent allocation, outside-contractor fee, or ownership withdrawal. Subtract deductible service compensation before applying the profit percentage. Build separate columns for outside basis, inside basis, and value. For debt, write the transferred balance and retained allocation on different lines. Before using distribution formulas, scan for marketable securities, contributed property, and changes in hot-asset interests. Process cash before receivables, inventory, and other property.
The full lesson (about 8,034 words, 54 min read) adds 16 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- II.C3
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