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 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.