Two engineers pool $80,000 in cash and a $120,000 patent to launch an LLC taxed as a partnership. Five years later one partner dies mid-year, the IRS opens an examination of the 2024 return, and a $300,000 imputed underpayment lands on the books. Whether that liability stays with the entity or pushes out to the partners turns on a single election made years earlier.
A partnership exists when two or more persons join to carry on a trade, business, or financial operation and divide the profits. No formal document is required, but a written partnership agreement governs allocations, distributions, management rights, transfer restrictions, dissolution triggers, and the identity of the Partnership Representative. Where the agreement is silent, state law and the default rules of Subchapter K control.
§721 nonrecognition. Neither partner nor partnership recognizes gain or loss when property is contributed in exchange for a partnership interest. Three exceptions matter:
- §721(b) investment company rule. Contributions to a partnership that would be an investment company if incorporated trigger gain recognition.
- Disguised sale (§707(a)(2)(B)). A contribution followed by a related distribution within two years is presumed a sale unless rebutted.
Common mistakes
- Counting S-corp partners as one for §6221(b). Each S-corp shareholder counts, and the threshold is 100, not 100 entities.
- Treating the technical termination rule as still alive. The 50%-in-12-months rule was repealed for tax years beginning after 2017.
- Forgetting that net liability relief in a §721 contribution can trigger §731 gain when the relieved amount exceeds the contributing partner's basis in the contributed property.
Bottom line
- §721 grants nonrecognition on property contributions in exchange for an interest; basis carries over (substituted basis to partner, transferred basis to partnership) and outside basis includes the partner's share of partnership liabilities
- General partners have unlimited liability and pay SE tax on distributive share; limited partners cap liability at capital contributed and avoid SE tax, but guaranteed payments for services stay SE
- A partner's death closes the tax year for that partner only; the partnership continues if two or more partners remain (the technical termination rule was repealed after 2017)
- Form 1065 is due the 15th day of the 3rd month (March 15 for calendar year); the §6698 late-filing penalty is $245 per partner per month, up to 12 months
Exam shortcut
March 15 / 100 / 45. Form 1065 due March 15. Opt-out requires ≤100 eligible partners (count S-corp shareholders individually). Push-out election deadline is 45 days from FPA. Hot assets = ordinary. On any sale of a partnership interest under §741, immediately ask whether unrealized receivables or inventory exist; if yes, carve out §751 ordinary income before computing capital gain. COD = partner-level §108.
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Learning objectives
- 2
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