Form 541 - Partnerships - Department Of Treasury Internal Revenue Service

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Capital is not material. In general, capital is

Both spouses materially participate in the

event described in (1), earlier, the date of termi-

trade or business (see Passive Activity

nation is the date the partnership completes the

not a material income-producing factor if the

Limitations in the Instructions for Form

winding up of its affairs. For the event described

income of the business consists principally of

fees, commissions, or other compensation for

1065 for a definition of material partici-

in (2), earlier, the date of termination is the date

personal services performed by members or

pation).

of the sale or exchange of a partnership interest

employees of the partnership.

that, by itself or together with other sales or

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Both spouses elect this treatment.

exchanges in the preceding 12 months, trans-

Capital interest. A capital interest in a part-

If both spouses elect this treatment, all income,

fers an interest of 50% or more in both capital

nership is an interest in its assets that is distrib-

gains, losses, deductions, and credits are di-

and profits.

utable to the owner of the interest in either of the

vided based on each spouse’s interest in the

Short period return. If a partnership is termi-

following situations.

joint venture and both are treated as sole propri-

nated before the end of the tax year, Form 1065

etors for both income and self-employment tax.

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The owner withdraws from the partner-

must be filed for the short period, which is the

ship.

If the husband and wife do not make the

period from the beginning of the tax year through

election to treat their joint venture as sole propri-

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the date of termination. The return is due the

The partnership liquidates.

etorships, each spouse should carry his or her

15th day of the fourth month following the date of

share of the partnership income or loss from

termination. See Partnership Return (Form

The mere right to share in earnings and profits

Schedule K-1 (Form 1065) to their joint or sepa-

1065), later, for information about filing Form

is not a capital interest in the partnership.

rate Form(s) 1040. Each spouse should include

1065.

his or her respective share of self-employment

Gift of capital interest. If a family member (or

income on a separate Schedule SE (Form

Conversion of partnership into limited liabil-

any other person) receives a gift of a capital

1040), Self-Employment Tax. This generally

ity company (LLC). The conversion of a part-

interest in a partnership in which capital is a

does not increase the total tax on the return, but

nership into an LLC classified as a partnership

material income-producing factor, the donee’s

it does give each spouse credit for social secur-

for federal tax purposes does not terminate the

distributive share of partnership income is sub-

ity earnings on which retirement benefits are

partnership. The conversion is not a sale, ex-

ject to both of the following restrictions.

based.

change, or liquidation of any partnership inter-

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It must be figured by reducing the partner-

est; the partnership’s tax year does not close;

ship income by reasonable compensation

Partnership Agreement

and the LLC can continue to use the partner-

for services the donor renders to the part-

ship’s taxpayer identification number.

nership.

The partnership agreement includes the original

However, the conversion may change some

agreement and any modifications. The modifica-

of the partners’ bases in their partnership inter-

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The donee’s distributive share of partner-

tions must be agreed to by all partners or

ests if the partnership has recourse liabilities

ship income attributable to donated capital

adopted in any other manner provided by the

that become nonrecourse liabilities. Because

must not be proportionately greater than

partnership agreement. The agreement or modi-

the partners share recourse and nonrecourse

the donor’s distributive share attributable

fications can be oral or written.

liabilities differently, their bases must be ad-

to the donor’s capital.

Partners can modify the partnership agree-

justed to reflect the new sharing ratios. If a

ment for a particular tax year after the close of

decrease in a partner’s share of liabilities ex-

Purchase. For purposes of determining a

the year but not later than the date for filing the

ceeds the partner’s basis, he or she must recog-

partner’s distributive share, an interest pur-

partnership return for that year. This filing date

nize gain on the excess. For more information,

chased by one family member from another

does not include any extension of time.

see Effect of Partnership Liabilities under Basis

family member is considered a gift from the

of Partner’s Interest, later.

If the partnership agreement or any modifica-

seller. The fair market value of the purchased

The same rules apply if an LLC classified as

tion is silent on any matter, the provisions of

interest is considered donated capital. For this

a partnership is converted into a partnership.

local law are treated as part of the agreement.

purpose, members of a family include only

spouses, ancestors, and lineal descendants (or

IRS e-file (Electronic Filing)

a trust for the primary benefit of those persons).

Terminating a

Example. A father sold 50% of his business

to his son. The resulting partnership had a profit

Partnership

of $60,000. Capital is a material in-

come-producing factor. The father performed

A partnership terminates when one of the follow-

Certain partnerships with more than 100 part-

services worth $24,000, which is reasonable

ing events takes place.

ners are required to file Form 1065, Schedules

compensation, and the son performed no serv-

K-1, and related forms and schedules electroni-

ices. The $24,000 must be allocated to the fa-

1. All its operations are discontinued and no

cally (e-file). Other partnerships generally have

ther as compensation. Of the remaining $36,000

part of any business, financial operation, or

the option to file electronically. For details about

of profit due to capital, at least 50%, or $18,000,

venture is continued by any of its partners

IRS e-file, see the Form 1065 instructions.

must be allocated to the father since he owns a

in a partnership.

50% capital interest. The son’s share of partner-

2. At least 50% of the total interest in partner-

ship profit cannot be more than $18,000.

ship capital and profits is sold or ex-

Exclusion From

changed within a 12-month period,

Husband-wife partnership. If spouses carry

including a sale or exchange to another

on a business together and share in the profits

Partnership Rules

partner.

and losses, they may be partners whether or not

they have a formal partnership agreement. If so,

Unlike other partnerships, an electing large part-

they should report income or loss from the busi-

Certain partnerships that do not actively conduct

nership does not terminate on the sale or ex-

ness on Form 1065. They should not report the

a business can choose to be completely or par-

change of 50% or more of the partnership

income on a Schedule C (Form 1040) in the

tially excluded from being treated as partner-

interests within a 12-month period.

name of one spouse as a sole proprietor. How-

ships for federal income tax purposes. All the

See section 1.708-1(b) of the regulations for

ever, the husband and wife can elect not to treat

partners must agree to make the choice, and the

more information on the termination of a partner-

the joint venture as a partnership if they meet

partners must be able to compute their own

ship. For special rules that apply to a merger,

each of the following requirements.

taxable income without computing the partner-

consolidation, or division of a partnership, see

ship’s income. However, the partners are not

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sections 1.708-1(c) and 1.708-1(d) of the regu-

The only members of the joint venture are

exempt from the rule that limits a partner’s dis-

lations.

the husband and wife.

tributive share of partnership loss to the ad-

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The filing status of the husband and wife is

Date of termination. The partnership’s tax

justed basis of the partner’s partnership interest.

married filing separately.

year ends on the date of termination. For the

Nor are they exempt from the requirement of a

Publication 541 (April 2008)

Page 3

Form 541 - Partnerships - Department Of Treasury Internal Revenue Service - 2008 Page 3

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