Forming a business partnership is usually tax-free. Of course, this is tax law, so you must meet the basic requirements for a tax-free formation, and you need to avoid the situations that cause you to owe taxes on the transfer of property.

Requirements to Qualify

To qualify for tax-free creation of a partnership, you must exchange property for a partnership interest.

Overall, the partnership rules are extremely flexible: they provide for tax-free transfers whether forming a new partnership or bringing a new partner into an existing partnership, regardless of the size of the partnership interest received.

Partnership Interest Exchanged for Services Is Taxable

If you exchange services for a partnership interest, you recognize income equal to the value of the partnership interest received.

Tax Consequences of Property Transfer

If you transfer property for a partnership interest, the following occurs:

• You recognize neither gain nor loss upon transfer.  
• Your basis in the partnership interest is the adjusted basis of the property transferred plus cash contributed.  
• Your capital account (which is a measure of your economic investment in the partnership) is the fair market value of the cash and property contributed.  
• Your holding period in the partnership interest includes the holding period during which you held the property you transferred, if that property was a capital asset or a Section 1231 property in your hands.

The following apply to the partnership:

• The partnership recognizes neither gain nor loss when it receives cash or property from a partner.  
• The partnership’s basis in the property received is its adjusted basis.  
• The partnership’s holding period in the property includes your holding period.

Can You Owe Taxes?

Yes, in a few situations:

Boot. There’s no provision in the tax code for you to receive cash and/or property from the partnership in the transaction (also known as “boot”). So, if you receive boot in a transfer of property to a partnership, you will have a taxable transfer.

Transfer of debt. Your basis in your partnership interest cannot be less than $0. Any event (such as the transfer of debt to a partnership) that would reduce your basis in your partnership interest below $0 creates taxable income to the extent it exceeds your basis.

Avoid Taxes

Avoid tax-generating headaches by adhering to the following practices:

• Don’t receive a partnership interest in exchange for services to the partnership.  
• Don’t receive “boot” when exchanging cash and/or property for a partnership interest.  
• If you transfer debt to a partnership, be sure you have sufficient basis in your partnership interest to avoid having to recognize taxable income.  
• Don’t engage in subsequent transactions that could lead to a disguised sale reclassification.

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