Why partnerships are the most flexible entity
Partnerships can make special allocations — dividing specific items differently from the general profit ratio — provided the allocations have substantial economic effect. In practice, that means capital accounts are properly maintained, liquidating distributions follow capital accounts, and partners with deficit balances have a restoration obligation (or a qualified income offset applies).
IMPORTANT — §704(c): When a partner contributes property whose fair value differs from its basis, the built-in gain or loss must be allocated to the contributing partner when the property is later sold. You cannot shift a pre-contribution gain to other partners.
Distributions
| Type | Treatment |
|---|---|
| Current cash | Tax-free to the extent of basis; excess is capital gain |
| Current property | Carryover basis, capped at the partner's remaining outside basis; no gain normally |
| Liquidating | Remaining basis allocated to distributed property; loss recognized only if the distribution consists solely of cash, unrealized receivables, and inventory |
The Section 754 election
Normally a buyer of a partnership interest gets an outside basis equal to the purchase price, but the partnership's inside basis in its assets is unchanged — creating a mismatch that can tax the new partner on appreciation they effectively paid for.
A §754 election allows the partnership to adjust inside basis (under §743(b) for transfers, §734(b) for distributions) so it aligns with the buyer's outside basis. It is beneficial for incoming partners when assets are appreciated — but it is binding on all future years unless revoked with IRS consent, and it creates ongoing administrative complexity.
EXAMPLE: A partner buys a one-third interest for $500,000 when the partnership's assets have an inside basis of $900,000 but a fair value of $1,500,000. Without a §754 election, if the partnership sells those assets, the new partner is allocated a share of gain that economically belongs to the seller. With the election, a $200,000 basis step-up is allocated specifically to the incoming partner.
Loss limitation stack
Apply in strict order: basis → at-risk → passive activity → excess business loss limitation.
EXAM TIP: Guaranteed payments are deductible by the partnership and are ordinary and self-employment income to the recipient — unlike a distributive share allocation to a limited partner, which may escape SE tax.