A father gifts his daughter a 30% interest in his medical practice partnership and tries to shift $60,000 of income to her lower bracket. §704(e) blocks the move: capital is not a material income-producing factor in a services partnership.
The partnership computes ordinary business income on Form 1065, page 1, then separately states items that retain character at the partner level: capital gains, §1231 gains, §179 expense, charitable contributions, interest, dividends, and credits. Partners report distributive share whether or not cash is distributed. Income increases outside basis; losses and distributions reduce it. Losses run through §704(d) basis, then §465 at-risk, then §469 passive before deduction.
Payments to a partner for services or use of capital, determined without regard to partnership income. Deductible by the partnership, reducing ordinary income passed through. Ordinary income to the partner on K-1 box 4, subject to SE tax when paid for services.
KEY: A guaranteed payment is NOT a distribution. The partner pays SE tax directly; no W-2 wages or payroll withholding.
Common mistakes
- Treating an LLC member's distributive share as automatically non-SE. Active LLC managers owe SE tax (Soroban line of cases).
- Deducting guaranteed payments at the partner level. They are deducted by the partnership.
- Recognizing gain on a property distribution. Property takes carryover basis, no gain except §751 hot assets.
Bottom line
- Partnership files Form 1065 by March 15; pays no entity-level tax; each partner receives a Schedule K-1.
- Partners report their distributive share whether or not the cash is actually distributed.
- General partners' distributive share plus guaranteed payments equals SE earnings (15.3% up to $176,100 in 2025; 2.9% Medicare thereafter).
- Limited partners are exempt under §1402(a)(13); only guaranteed payments for services trigger SE tax, and LLC member-managers cannot rely on this exclusion (Soroban).
Exam shortcut
General partner ordinary share + guaranteed payment = SE income. Limited partner share alone = NOT SE. Distribution problems: walk basis. Income up, then distributions, then losses. Distribution above basis = capital gain. Family partnership red flag: services entity (medicine, law, consulting). Capital not material = invalid under §704(e).
The full lesson (about 1,132 words, 8 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2
Browse all free EA Part 2 lessons or jump into free EA Part 2 practice questions.