AICPA Representative Tasks (verbatim). 1. Application: Calculate the tax implications to a partner for the contribution to a partnership of noncash property that has appreciated or depreciated in value. 2. Application: Calculate the tax implications of various types of payments to a partner, including guaranteed payments and a nonliquidating distribution. 3. Analysis: Derive the tax implications to a partner and partnership for a proposed transaction, including a contribution of noncash property, a nonliquidating distribution of noncash property or the sale of a partnership interest.
Partnership formation operates under a general nonrecognition regime. When a partner contributes property to a partnership in exchange for a partnership interest, §721 defers gain or loss recognition. This parallels §351 for corporations but with critical differences in basis mechanics.
KEY: Unlike §351, there is no 80% control requirement for §721 nonrecognition. A partner contributing property for a 5% interest still qualifies for deferral.
Common mistakes
- Ignoring §704(c) built-in gain allocations. When appreciated property is contributed, the pre-contribution gain must be allocated to the contributing partner. Trap: "all gains are split per partnership percentages." Correct: built-in gain at contribution follows the contributing partner.
- Forgetting liabilities affect outside basis. Partnership assumption of a contributor's liability reduces outside basis; the partner's share of partnership liabilities increases it. Trap: "liability transfer has no basis effect." Correct: net liability relief can reduce basis to zero and trigger gain.
- Treating guaranteed payments as distributions. Guaranteed payments are ordinary income to the recipient and deductible by the partnership. Trap: "guaranteed payments reduce outside basis like distributions." Correct: they are compensation, not distributions.
Bottom line
- §721 grants nonrecognition on property contributions with no control requirement (unlike §351); the partner takes a substituted basis equal to the contributed property's basis
- Inside basis (partnership's basis in assets) and outside basis (partner's basis in interest) are tracked separately; outside basis equals contributed basis plus cash minus net liability relief
- Built-in gains and losses on contributed property are allocated to the contributing partner under §704(c) when the property is sold
- Guaranteed payments are deductible by the partnership and ordinary income (plus SE tax for services) to the recipient, regardless of partnership profits
Exam shortcut
"721-723-722" sequence for contributions: §721 = nonrecognition rule; §723 = partnership takes carryover basis (inside); §722 = partner takes substituted basis (outside). Recite the sequence to remember which section governs which party's basis. Hot assets = "RI" test: Receivables (including recapture) and Inventory. If the partnership holds either, §751 analysis is mandatory on any sale of a partnership interest. No RI, no §751 recharacterization.
The full lesson (about 2,560 words, 17 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- III.D1
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