Business Entities · Partnerships

Contribution of property and/or services to partnership (e.g., partnership's basis, property subject to indebtedness)

Contribution is where the partnership’s most attractive feature is on display and where its least intuitive rules originate. Property goes in without tax, in circumstances far more generous than the corporate rules allow — no control requirement, no timing requirement, no percentage test. But everything that was true about the property before the contribution has to stay true afterwards, because otherwise the contribution would be a costless way of changing character, shifting gain to another taxpayer, or converting a service fee into an equity stake. Sections 704(c), 724 and 752 are all there for that reason.

The rule

No gain or loss. no gain or loss is recognised to a partnership or to any of its partners on a contribution of property to the partnership in exchange for an interest in it (IRC § 721(a))^TY2026

Except for an investment company. nonrecognition does not apply to gain realised on a transfer of property to a partnership that would be treated as an investment company within the meaning of IRC § 351 if the partnership were incorporated (IRC § 721(b))^TY2026

The contributor’s basis in the interest. the basis of a partnership interest acquired by contributing property, including money, is the amount of the money plus the adjusted basis of the property to the contributing partner at the time of contribution, increased by any gain recognised under IRC § 721(b) (IRC § 722)^TY2026

The partnership’s basis in the property. the basis of property contributed to a partnership is its adjusted basis to the contributing partner at the time of contribution, increased by any gain recognised under IRC § 721(b) (IRC § 723)^TY2026

Services are not property. IRC § 721 does not apply where a partner gives up part of the right to be repaid contributions in favour of another partner as compensation for services. The value of an interest in partnership capital transferred as compensation for services is income to that partner under IRC § 61, measured at fair market value at the time of transfer for past services or at the time the services are rendered where the transfer is conditioned on future services. A capital interest for services rendered to the partnership is a guaranteed payment under IRC § 707(c) (Reg. § 1.721-1(b)(1), (2))^TY2026

Built-in gain stays with the contributor. income, gain, loss and deduction with respect to property contributed by a partner must be shared among the partners so as to take account of the variation between the partnership basis in the property and its fair market value at the time of contribution (IRC § 704(c)(1)(A))^TY2026

And cannot be shifted by distributing the property. where contributed property is distributed, directly or indirectly, to a partner other than the contributor within 7 years of contribution, the contributing partner is treated as recognising the gain or loss that would have been allocated to them under IRC § 704(c)(1)(A) had the property been sold at fair market value at the time of the distribution, with character determined as if the partnership had sold it to the distributee and with appropriate basis adjustments (IRC § 704(c)(1)(B))^TY2026

Unrealized receivables keep their character forever. gain or loss recognised by the partnership on disposing of property that was an unrealised receivable in the contributing partner hands immediately before contribution is ordinary, with no time limit (IRC § 724(a))^TY2026

Inventory keeps it for five years. gain or loss recognised by the partnership on disposing of property that was an inventory item in the contributing partner hands immediately before contribution is ordinary if the disposition occurs within the 5-year period beginning on the date of contribution (IRC § 724(b))^TY2026

And so does a built-in capital loss. loss recognised by the partnership on disposing of property that was a capital asset in the contributing partner hands immediately before contribution is capital loss, if the disposition occurs within the 5-year period beginning on the date of contribution, to the extent the adjusted basis exceeded fair market value immediately before the contribution (IRC § 724(c))^TY2026

Liabilities. an increase in a partner share of partnership liabilities, or in the partner individual liabilities by reason of assuming partnership liabilities, is treated as a contribution of money by that partner to the partnership; a decrease in either is treated as a distribution of money to the partner (IRC § 752(a), (b))^TY2026

With gain if the relief exceeds basis. gain is not recognised to a partner on a distribution except to the extent money distributed exceeds the adjusted basis of the partner interest immediately before it; loss is not recognised except on a liquidating distribution consisting only of money, unrealised receivables and inventory, and then only to the extent the basis of the interest exceeds the money plus the basis of those items. No gain or loss is recognised to the partnership (IRC § 731(a), (b))^TY2026

Current figures

How it works in practice

IRC § 721 is deliberately broader than its corporate counterpart. A contribution qualifies whether the contributor ends up owning one percent or ninety-nine, whether they are joining at formation or twenty years later, and whether or not anyone else contributes at the same time. There is no analogue of the corporate control test, which is why a partnership is so much easier to add capital to.

The two basis rules should be read together, because between them they preserve the built-in gain twice over. The contributor takes a substituted basis in the partnership interest equal to what they had in the property (IRC § 722); the partnership takes a transferred basis in the property equal to the same figure (IRC § 723). So appreciated property produces the same unrecognised gain twice, once inside the partnership and once outside it. Both will eventually be taxed, which is the design.

That duplication is exactly why IRC § 704(c) exists. Without it, the inside gain would be shared among all the partners when the property is sold, so the contributor would have shifted their own appreciation onto people who had nothing to do with it. IRC § 704(c)(1)(A) requires that the income, gain, loss and deduction on contributed property be shared so as to take account of the variation between basis and value at the time of contribution — in practice, the pre-contribution gain is allocated back to the contributor when it is recognised. The same logic runs through depreciation: a partner who contributes a depreciated asset cannot give the other partners depreciation deductions on basis they never paid for.

IRC § 704(c)(1)(B) closes the escape route. If the answer to “how do I avoid the built-in gain coming back to me?” were “distribute the property to somebody else”, the section would be pointless. So a distribution of the contributed property to a non-contributing partner within seven years accelerates the contributor’s built-in gain as though the property had been sold at value on that date.

IRC § 724 preserves character rather than amount, and its three limbs have deliberately different durations. An unrealized receivable is ordinary in the partnership’s hands forever — there is no time limit, because a receivable is nothing but accrued ordinary income and the passage of time does not change that. Inventory is ordinary for five years, on the footing that after five years the property has plausibly been repurposed. A built-in capital loss stays capital for five years, and only to the extent of the loss that existed at contribution — appreciation after contribution is not caught.

Services are the sharp edge of the section. IRC § 721 applies to a contribution of property, and services are not property. Reg. § 1.721-1(b) explains the mechanism: where a partner gives up part of their right to be repaid contributions in favour of a service partner, that transfer of capital is compensation, taxable under IRC § 61 at fair market value, and — where the services were rendered to the partnership — it is a guaranteed payment under IRC § 707(c). The service partner has income even though no cash changed hands and may have to fund the tax from elsewhere.

Contributing property subject to debt combines two rules that pull in opposite directions. The contributor is relieved of the whole liability, which is a deemed distribution under IRC § 752(b); but they pick up their own share of it as a partner, which is a deemed contribution under IRC § 752(a). Only the net matters. Where the net deemed distribution exceeds the contributor’s basis in the interest as increased under IRC § 722, the excess is gain under IRC § 731(a)(1) — and a contribution that was supposed to be tax-free produces tax.

Scenarios

How this has changed

The core provisions have not been amended in a way that affects this topic. The period in IRC § 704(c)(1)(B) is the one figure that has moved: it was five years when enacted and was extended to seven for property contributed after 22 June 1984 under later legislation, which means it is now out of step with the five-year periods in IRC § 724(b) and (c). Material that gives a single period for both rules is describing a symmetry that has not existed for a long time, and the mismatch is a favourite of question writers precisely because it looks like an error.

What has changed around the section is the significance of a services contribution. The receipt of a capital interest for services has always been taxable under Reg. § 1.721-1(b). The receipt of a profits interest for services is treated very differently, and the administrative position that has governed it for three decades is not in the statute or the regulation at all. Anyone advising on a service partner’s admission needs to know which of the two is being granted, and the answer turns on the definition of a capital interest — an interest in the assets distributable on withdrawal or liquidation, rather than a mere right to share in profits.

Exam focus

The commonest computation asks for the contributor’s outside basis and the partnership’s inside basis after a contribution. Both are the contributor’s adjusted basis, and both are the same figure — the question usually offers fair market value as a distractor for one or both.

The second shape gives contributed property with a built-in gain and a later sale, and asks how the gain is allocated. Split it: the pre-contribution variation goes to the contributor, and only the post- contribution movement is shared under the ordinary sharing ratio.

Watch for character questions. If the property was an unrealized receivable, the answer is ordinary whenever the sale happens. If it was inventory or built-in-loss capital property, check the date against the five-year period. And where a question involves a contribution subject to debt, the answer is nearly always about the net deemed distribution rather than about IRC § 721 at all.

Check yourself

1. A partner contributes equipment worth $400,000 with an adjusted basis of $150,000 for a 20 percent interest. What is the partner’s basis in the interest, and the partnership’s basis in the equipment?

Answer: $150,000 and $150,000. IRC § 722 gives the contributor a substituted basis equal to the adjusted basis of the contributed property, and IRC § 723 gives the partnership a transferred basis equal to the same figure. Fair market value is irrelevant to both, and the $250,000 of built-in gain is preserved twice — once inside the partnership and once outside it.

2. A partner contributes inventory with a basis of $80,000 and a value of $130,000. The partnership, which holds it as a capital asset, sells it for $135,000 in the sixth year after contribution. What is the character of the gain?

Answer: capital. IRC § 724(b) converts gain to ordinary only where the disposition occurs within the five-year period beginning on the date of contribution, and the sixth year is outside it. The $50,000 of pre-contribution gain is still allocated to the contributing partner under IRC § 704(c)(1)(A) — the timing rule affects character, not who bears the gain.

3. A person receives a 10 percent capital interest worth $200,000 in exchange for services rendered to the partnership. What are the consequences?

Answer: $200,000 of ordinary income to the recipient at fair market value under IRC § 61, as Reg. § 1.721-1(b)(1) provides, and a guaranteed payment under IRC § 707(c) because the services were rendered to the partnership. IRC § 721 does not apply, since services are not property. The recipient’s basis in the interest is $200,000, and the amount is self-employment income with no withholding.

4. Property contributed by partner A with a $300,000 built-in gain is distributed to partner B four years later, when its value is unchanged. What happens?

Answer: A recognises $300,000 of gain. Under IRC § 704(c)(1)(B), where contributed property is distributed to a partner other than the contributor within seven years, the contributor is treated as recognising the gain that would have been allocated to them under IRC § 704(c)(1)(A) had the property been sold at value on the date of distribution. Character is determined as if the partnership had sold to B, and basis adjustments follow.

5. A partner contributes property with a basis of $60,000 subject to a $250,000 liability the partnership assumes. The partner’s share of partnership liabilities afterwards is $50,000. What gain, if any, is recognised?

Answer: $140,000. The partner’s basis begins at $60,000 under IRC § 722. The net deemed distribution is $250,000 relieved less $50,000 picked up, so $200,000 (IRC § 752(a), (b)). Basis is reduced to zero and the $140,000 excess is gain under IRC § 731(a)(1), treated as gain from the sale or exchange of the partnership interest.