Key Takeaways
- Section 721 provides nonrecognition when property is contributed for a partnership interest.
- Contributing services triggers immediate ordinary income recognition.
- Outside basis = partner basis in partnership interest; Inside basis = partnership basis in property.
- Boot (cash/liabilities) may trigger gain recognition.
- Partnership tacks the contributing partner holding period.
- Investment company exception can trigger gain on diversification.
Partnership Formation
Why This Matters for the Exam
Partnership formation is fundamental to Part 2. The exam tests the tax-free nature of property contributions, the taxable treatment of service contributions, and the critical inside/outside basis concepts.
Exam Note: For the May 2025 - February 2026 testing window, you are tested on partnership rules as of December 31, 2024 (Tax Year 2024).
Expect at least 4-5 questions on partnership formation.
Section 721: Nonrecognition on Formation
The general rule is that no gain or loss is recognized when property is contributed to a partnership in exchange for a partnership interest.
| Contribution Type | Tax Treatment |
|---|---|
| Property | No gain/loss (§721) |
| Services | Ordinary income recognized |
| Property + Boot | Gain to extent of boot |
Property vs. Services
| Contributes | Result |
|---|---|
| Property (real estate, equipment, inventory, IP) | Tax-free under §721 |
| Services (legal work, consulting, labor) | Taxable—FMV of interest received = ordinary income |
Key Point: If you contribute services for a partnership interest, you recognize ordinary income equal to the FMV of the interest received. This is immediate taxation.
Inside Basis vs. Outside Basis
These are the two most fundamental concepts in partnership taxation:
| Concept | What It Is | What It Determines |
|---|---|---|
| Outside Basis | Partner's basis in partnership interest | Loss limits, distribution taxation, sale gain |
| Inside Basis | Partnership's basis in contributed property | Depreciation, sale gain by partnership |
Outside Basis Calculation (Formation)
| Component | Effect |
|---|---|
| Basis of property contributed | Start |
| + Cash contributed | Add |
| - Liabilities assumed by partnership | Subtract |
| + Share of partnership liabilities | Add |
| = Outside Basis |
Inside Basis Rule
| Rule | Description |
|---|---|
| Carryover basis | Partnership takes partner's adjusted basis |
| No step-up | FMV is irrelevant |
| Built-in gain/loss | Preserved for later recognition |
Boot and Gain Recognition
"Boot" can trigger gain:
| Type of Boot | Effect |
|---|---|
| Cash received | Gain recognized |
| Liabilities assumed > share allocated | Gain recognized |
| Marketable securities | May be treated as cash |
Gain Formula:
- Gain recognized = Lesser of realized gain OR boot received
Holding Period Tacking
| Rule | Description |
|---|---|
| Partnership tacks | Partner's holding period carries over |
| Capital/§1231 assets | Full tacking |
| Ordinary income assets | Holding period starts fresh |
Formation Example
| Partner A Contribution | Amount |
|---|---|
| Land basis | $40,000 |
| Land FMV | $100,000 |
| Liability on land | $20,000 |
| Partnership interest received | 25% |
| Calculation | Amount |
|---|---|
| Outside basis start | $40,000 |
| Less: Liability assumed | ($20,000) |
| Plus: Share of liability (25%) | $5,000 |
| Outside Basis | $25,000 |
| Inside Basis (to partnership) | $40,000 |
Real-World Scenario
Scenario: Partner A contributes land (basis $40k, FMV $100k) for a 25% interest. Partner B contributes services worth $100k for a 25% interest.
- Partner A: No gain recognized (§721). Outside basis = $40k.
- Partner B: $100k ordinary income recognized. Outside basis = $100k (FMV of interest).
On the Exam
Expect 4-5 questions on formation, typically:
- Gain Recognition Questions: "How much gain does the contributing partner recognize?"
- Service Questions: "What is the tax consequence of contributing services?"
- Basis Questions: "What is the partner's outside basis?"
- Inside/Outside Questions: "What is the partnership's basis in the property?"
The key is to remember: Property = no gain (§721). Services = ordinary income. Outside = partner's basis in interest. Inside = partnership's basis in property (carryover).
Partner A contributes land with FMV $100,000 and basis $40,000 for a 25% interest. How much gain does Partner A recognize?
Partner B contributes services valued at $50,000 for a 10% partnership interest. What is the tax consequence?
Partner contributes property (basis $30,000, FMV $80,000). Partnership assumes $20,000 liability. What is outside basis?