A partnership, for tax purposes, is defined by negative implication.  It is a “joint venture” or similar organization engaged in business that is not classified as a trust, corporation or estate. Partnerships, unlike corporations, generally pay no income taxes. Taxes are instead paid byn the partners the partners, who are taxed on their share of partnership income, deductions and losses.

For reporting purposes, each partner receives a Schedule K-1, which indicates the partner’s “share” of partnership income. Partners are taxed on their “distributive shares” of partnership income regardless of whether the partnership actually makes any distribution to any of the partners, or even whether the partnership has any assets to distribute. For example, an asset of accrual basis partnership might consist of a large account receivable. This would constitute income to the parnership for which each partner would be required to report his distributive share.

The characterization of partnership income is determined, and frozen, at the partnership level. Thus, the sale of a partnership asset meeting all capital gains requirements would be reported as capital gain on the individual partner’s 1040. (By contrast, distributions of corporate earnings, whatever their source, are characterized as ordinary income at the shareholder level.)

A partner’s “distributive share” of partnership income, deductions and losses is itself determined by reference to the partnership agreement. Since the partners themselves draft the partnership agreement, the partnership form accords the partners great flexibility in determining the incidence of taxation at the partner level. For example, if partner A does not expect income in year one, the partnership agreement could allocate losses in that year to other partners who could better make use of those losses. One sizeable constraint imposed upon the partnership agreement lies in the requirement that allocations enumerated therein comport with economic reality. Thus, two partners could not, consistent with this rule, each contribute $10,000 to an oil venture and allocate all of the losses to one partner and all of the income (if any) to the other.

Another attractive feature of the partnership form is the ability of the partnership to generate losses which can be currently utilized by its partners. (In contrast, shareholders of a C corporation cannot deduct the corporation’s losses for the year. Before they can realize any of the corporation’s losses, they must actually sell their interest in the corporation.) This characteristic often makes the partnership form a good vehicle for the traditional tax shelter, where large losses are expected in the early years. If the venture later becomes profitable, the entity can be changed to a corporation. At that point, the former partners (now shareholders) would no longer be taxed on their distributive shares of income; of course, the corporation would itself be required to pay income tax at that point.

A partner’s basis fluctuates throughout the life of the partnership. Initially, a partner’s basis is the sum of the partner’s capital contributions to the partnership plus his share of the partnership’s liabilities. For reasons which are discussed below, a partner’s basis in the partnership is increased by his distributive share of partnership income and decreased by his distributive share of partnership losses.

A partner’s allowable “distributive share” of partnership losses equals, but cannot exceed his “basis” in the partnership. Once a partner has exhausted his basis (e.g., by claiming losses or receiving distributions), he may not claim further partnership losses until his basis is increased, either by a contribution or by a new partnership liability. This rule prevents a partner from claiming losses in excess of his actual economic stake in the partnership.

Distributive share income reported by individual partners creates basis which will later permit partners to receive partnership destributions tax-free. Partnership distributions are generally not a taxable event since distributions simply reduce the partner’s basis in the partnership. The interplay of the income and basis rules in partnership taxation have as their unifying theme the object to impose tax at the partner level on partnership income, without regard to whether, when or how partnership assets are actually distributed to the partners.

Deciding whether to operate a business as a partnership requires careful consideration of nontax consequences attendant upon this choice of business form. A partnership will usually have a closer nexus to its partners than does a corporation to its shareholders. Consequently, just income and losses of a general partnership flow out to the partners, so too do the obligations and debts. Unlike corporate shareholders, general partners are in a very real sense personally liable for the partnership’s obligations. Another unique feature of the general partnership lies in the authority of each partner to legally bind the partnership.

Partnerships will not automatically continue in existence following the death, bankruptcy, retirement or resignation of a partner. Moreover, because of their close legal ties, partners are given a right to choose their associates. Partners may also have the right to dissolve the partnership at will and withdraw their capital, thus declining to participate further in the risks and ventures of the partnership. In contrast, shareholders of a corporation must continue their investment unless the corporation is liquidated or purchasers for their stock can be found. Another characteristic that distinguishes partnerships from corporations is the usual lack of free transferability of interests in the former. Partners can transfer their entire partnership interest only if all other partners consent. No such constraint exists with respect to the transfer of corporate stock.

Since partnerships generally produce fewer tax revenues for the Treasury, the IRS may seek to tax as corporations entities which are characterized by the taxpayer as  partnerships. Even failure to incorporate under state law will not deter the IRS in this regard.  Before imposing corporate tax rules on the entity, the IRS must demonstrate that the entity more closely resembles a corporation for federal tax purposes than it does a partnership. Treasury Reg. § 301.7701 explicitly provides that if at least three of the following four factors are present, the IRS can tax the entity in question as a corporation, rather than a partnership: (1) continuity of life, (2) centralization of management, (3) limited liability, and (4) free transferability of interests.