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H&r Block Free Tax Return

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H&r Block Free Tax Return

H&r block free tax return Publication 541 - Main Content Table of Contents Forming a PartnershipOrganizations Classified as Partnerships Family Partnership Partnership Agreement Terminating a PartnershipIRS e-file (Electronic Filing) Exclusion From Partnership Rules Partnership Return (Form 1065) Partnership DistributionsSubstantially appreciated inventory items. H&r block free tax return Partner's Gain or Loss Partner's Basis for Distributed Property Transactions Between Partnership and PartnersGuaranteed Payments Sale or Exchange of Property Contribution of Property Contribution of Services Basis of Partner's InterestAdjusted Basis Effect of Partnership Liabilities Disposition of Partner's InterestSale, Exchange, or Other Transfer Payments for Unrealized Receivables and Inventory Items Liquidation at Partner's Retirement or Death Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA)Partnership Item. H&r block free tax return Small Partnerships and the Small Partnership Exception Small Partnership TEFRA Election Role of Tax Matters Partner (TMP) in TEFRA Proceedings Statute of Limitations and TEFRA Amended Returns and Administrative Adjustment Requests (AARs) How To Get Tax Help Forming a Partnership The following sections contain general information about partnerships. H&r block free tax return Organizations Classified as Partnerships An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes if its members carry on a trade, business, financial operation, or venture and divide its profits. H&r block free tax return However, a joint undertaking merely to share expenses is not a partnership. H&r block free tax return For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants. H&r block free tax return The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed after 1996. H&r block free tax return Organizations formed after 1996. H&r block free tax return   An organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members and it is none of the following. H&r block free tax return An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic. H&r block free tax return An organization formed under a state law that refers to it as a joint-stock company or joint-stock association. H&r block free tax return An insurance company. H&r block free tax return Certain banks. H&r block free tax return An organization wholly owned by a state, local, or foreign government. H&r block free tax return An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly traded partnerships). H&r block free tax return Certain foreign organizations identified in section 301. H&r block free tax return 7701-2(b)(8) of the regulations. H&r block free tax return A tax-exempt organization. H&r block free tax return A real estate investment trust. H&r block free tax return An organization classified as a trust under section 301. H&r block free tax return 7701-4 of the regulations or otherwise subject to special treatment under the Internal Revenue Code. H&r block free tax return Any other organization that elects to be classified as a corporation by filing Form 8832. H&r block free tax return For more information, see the instructions for Form 8832. H&r block free tax return Limited liability company. H&r block free tax return   A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. H&r block free tax return Unlike a partnership, none of the members of an LLC are personally liable for its debts. H&r block free tax return An LLC may be classified for federal income tax purposes as either a partnership, a corporation, or an entity disregarded as an entity separate from its owner by applying the rules in Regulations section 301. H&r block free tax return 7701-3. H&r block free tax return See Form 8832 and section 301. H&r block free tax return 7701-3 of the regulations for more details. H&r block free tax return A domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes. H&r block free tax return Organizations formed before 1997. H&r block free tax return   An organization formed before 1997 and classified as a partnership under the old rules will generally continue to be classified as a partnership as long as the organization has at least two members and does not elect to be classified as a corporation by filing Form 8832. H&r block free tax return Community property. H&r block free tax return    Spouses who own a qualified entity (defined later) can choose to classify the entity as a partnership for federal tax purposes by filing the appropriate partnership tax returns. H&r block free tax return They can choose to classify the entity as a sole proprietorship by filing a Schedule C (Form 1040) listing one spouse as the sole proprietor. H&r block free tax return A change in reporting position will be treated for federal tax purposes as a conversion of the entity. H&r block free tax return   A qualified entity is a business entity that meets all the following requirements. H&r block free tax return The business entity is wholly owned by spouses as community property under the laws of a state, a foreign country, or a possession of the United States. H&r block free tax return No person other than one or both spouses would be considered an owner for federal tax purposes. H&r block free tax return The business entity is not treated as a corporation. H&r block free tax return   For more information about community property, see Publication 555, Community Property. H&r block free tax return Publication 555 discusses the community property laws of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. H&r block free tax return Family Partnership Members of a family can be partners. H&r block free tax return However, family members (or any other person) will be recognized as partners only if one of the following requirements is met. H&r block free tax return If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest. H&r block free tax return If capital is not a material income-producing factor, they joined together in good faith to conduct a business. H&r block free tax return They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner. H&r block free tax return Capital is material. H&r block free tax return   Capital is a material income-producing factor if a substantial part of the gross income of the business comes from the use of capital. H&r block free tax return Capital is ordinarily an income-producing factor if the operation of the business requires substantial inventories or investments in plants, machinery, or equipment. H&r block free tax return Capital is not material. H&r block free tax return   In general, capital is not a material income-producing factor if the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership. H&r block free tax return Capital interest. H&r block free tax return   A capital interest in a partnership is an interest in its assets that is distributable to the owner of the interest in either of the following situations. H&r block free tax return The owner withdraws from the partnership. H&r block free tax return The partnership liquidates. H&r block free tax return   The mere right to share in earnings and profits is not a capital interest in the partnership. H&r block free tax return Gift of capital interest. H&r block free tax return   If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is a material income-producing factor, the donee's distributive share of partnership income is subject to both of the following restrictions. H&r block free tax return It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the partnership. H&r block free tax return The donee's distributive share of partnership income attributable to donated capital must not be proportionately greater than the donor's distributive share attributable to the donor's capital. H&r block free tax return Purchase. H&r block free tax return   For purposes of determining a partner's distributive share, an interest purchased by one family member from another family member is considered a gift from the seller. H&r block free tax return The fair market value of the purchased interest is considered donated capital. H&r block free tax return For this purpose, members of a family include only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons). H&r block free tax return Example. H&r block free tax return A father sold 50% of his business to his son. H&r block free tax return The resulting partnership had a profit of $60,000. H&r block free tax return Capital is a material income-producing factor. H&r block free tax return The father performed services worth $24,000, which is reasonable compensation, and the son performed no services. H&r block free tax return The $24,000 must be allocated to the father as compensation. H&r block free tax return Of the remaining $36,000 of profit due to capital, at least 50%, or $18,000, must be allocated to the father since he owns a 50% capital interest. H&r block free tax return The son's share of partnership profit cannot be more than $18,000. H&r block free tax return Business owned and operated by spouses. H&r block free tax return   If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. H&r block free tax return If so, they should report income or loss from the business on Form 1065. H&r block free tax return They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor. H&r block free tax return However, the spouses can elect not to treat the joint venture as a partnership by making a Qualified Joint Venture Election. H&r block free tax return Qualified Joint Venture Election. H&r block free tax return   A "qualified joint venture," whose only members are spouses filing a joint return, can elect not to be treated as a partnership for federal tax purposes. H&r block free tax return A qualified joint venture conducts a trade or business where: the only members of the joint venture are spouses filing jointly; both spouses elect not to be treated as a partnership; both spouses materially participate in the trade or business (see Passive Activity Limitations in the Instructions for Form 1065 for a definition of material participation); and the business is co-owned by both spouses and is not held in the name of a state law entity such as a partnership or LLC. H&r block free tax return   Under this election, a qualified joint venture conducted by spouses who file a joint return is not treated as a partnership for federal tax purposes and therefore does not have a Form 1065 filing requirement. H&r block free tax return All items of income, gain, deduction, loss, and credit are divided between the spouses based on their respective interests in the venture. H&r block free tax return Each spouse takes into account his or her respective share of these items as a sole proprietor. H&r block free tax return Each spouse would account for his or her respective share on the appropriate form, such as Schedule C (Form 1040). H&r block free tax return For purposes of determining net earnings from self-employment, each spouse's share of income or loss from a qualified joint venture is taken into account just as it is for federal income tax purposes (i. H&r block free tax return e. H&r block free tax return , based on their respective interests in the venture). H&r block free tax return   If the spouses do not make the election to treat their respective interests in the joint venture as sole proprietorships, each spouse should carry his or her share of the partnership income or loss from Schedule K-1 (Form 1065) to their joint or separate Form(s) 1040. H&r block free tax return Each spouse should include his or her respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax. H&r block free tax return   This generally does not increase the total tax on the return, but it does give each spouse credit for social security earnings on which retirement benefits are based. H&r block free tax return However, this may not be true if either spouse exceeds the social security tax limitation. H&r block free tax return   For more information on qualified joint ventures, go to IRS. H&r block free tax return gov, enter “Election for Qualified Joint Ventures” in the search box and select the link reading “Election for Husband and Wife Unincorporated Businesses. H&r block free tax return ” Partnership Agreement The partnership agreement includes the original agreement and any modifications. H&r block free tax return The modifications must be agreed to by all partners or adopted in any other manner provided by the partnership agreement. H&r block free tax return The agreement or modifications can be oral or written. H&r block free tax return Partners can modify the partnership agreement for a particular tax year after the close of the year but not later than the date for filing the partnership return for that year. H&r block free tax return This filing date does not include any extension of time. H&r block free tax return If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part of the agreement. H&r block free tax return Terminating a Partnership A partnership terminates when one of the following events takes place. H&r block free tax return All its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its partners in a partnership. H&r block free tax return At least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner. H&r block free tax return Unlike other partnerships, an electing large partnership does not terminate on the sale or exchange of 50% or more of the partnership interests within a 12-month period. H&r block free tax return See section 1. H&r block free tax return 708-1(b) of the regulations for more information on the termination of a partnership. H&r block free tax return For special rules that apply to a merger, consolidation, or division of a partnership, see sections 1. H&r block free tax return 708-1(c) and 1. H&r block free tax return 708-1(d) of the regulations. H&r block free tax return Date of termination. H&r block free tax return   The partnership's tax year ends on the date of termination. H&r block free tax return For the event described in (1), above, the date of termination is the date the partnership completes the winding up of its affairs. H&r block free tax return For the event described in (2), above, the date of termination is the date of the sale or exchange of a partnership interest that, by itself or together with other sales or exchanges in the preceding 12 months, transfers an interest of 50% or more in both capital and profits. H&r block free tax return Short period return. H&r block free tax return   If a partnership is terminated before the end of what would otherwise be its tax year, Form 1065 must be filed for the short period, which is the period from the beginning of the tax year through the date of termination. H&r block free tax return The return is due the 15th day of the fourth month following the date of termination. H&r block free tax return See Partnership Return (Form 1065), later, for information about filing Form 1065. H&r block free tax return Conversion of partnership into limited liability company (LLC). H&r block free tax return   The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate the partnership. H&r block free tax return The conversion is not a sale, exchange, or liquidation of any partnership interest; the partnership's tax year does not close; and the LLC can continue to use the partnership's taxpayer identification number. H&r block free tax return   However, the conversion may change some of the partners' bases in their partnership interests if the partnership has recourse liabilities that become nonrecourse liabilities. H&r block free tax return Because the partners share recourse and nonrecourse liabilities differently, their bases must be adjusted to reflect the new sharing ratios. H&r block free tax return If a decrease in a partner's share of liabilities exceeds the partner's basis, he or she must recognize gain on the excess. H&r block free tax return For more information, see Effect of Partnership Liabilities under Basis of Partner's Interest, later. H&r block free tax return   The same rules apply if an LLC classified as a partnership is converted into a partnership. H&r block free tax return IRS e-file (Electronic Filing) Please click here for the text description of the image. H&r block free tax return e-file Certain partnerships with more than 100 partners are required to file Form 1065, Schedules K-1, and related forms and schedules electronically (e-file). H&r block free tax return Other partnerships generally have the option to file electronically. H&r block free tax return For details about IRS e-file, see the Form 1065 instructions. H&r block free tax return Exclusion From Partnership Rules Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being treated as partnerships for federal income tax purposes. H&r block free tax return All the partners must agree to make the choice, and the partners must be able to compute their own taxable income without computing the partnership's income. H&r block free tax return However, the partners are not exempt from the rule that limits a partner's distributive share of partnership loss to the adjusted basis of the partner's partnership interest. H&r block free tax return Nor are they exempt from the requirement of a business purpose for adopting a tax year for the partnership that differs from its required tax year. H&r block free tax return Investing partnership. H&r block free tax return   An investing partnership can be excluded if the participants in the joint purchase, retention, sale, or exchange of investment property meet all the following requirements. H&r block free tax return They own the property as co-owners. H&r block free tax return They reserve the right separately to take or dispose of their shares of any property acquired or retained. H&r block free tax return They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase, sell, or exchange the investment property. H&r block free tax return Each separate participant can delegate authority to purchase, sell, or exchange his or her share of the investment property for the time being for his or her account, but not for a period of more than a year. H&r block free tax return Operating agreement partnership. H&r block free tax return   An operating agreement partnership group can be excluded if the participants in the joint production, extraction, or use of property meet all the following requirements. H&r block free tax return They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights. H&r block free tax return They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used. H&r block free tax return They do not jointly sell services or the property produced or extracted. H&r block free tax return Each separate participant can delegate authority to sell his or her share of the property produced or extracted for the time being for his or her account, but not for a period of time in excess of the minimum needs of the industry, and in no event for more than one year. H&r block free tax return However, this exclusion does not apply to an unincorporated organization one of whose principal purposes is cycling, manufacturing, or processing for persons who are not members of the organization. H&r block free tax return Electing the exclusion. H&r block free tax return   An eligible organization that wishes to be excluded from the partnership rules must make the election not later than the time for filing the partnership return for the first tax year for which exclusion is desired. H&r block free tax return This filing date includes any extension of time. H&r block free tax return See Regulations section 1. H&r block free tax return 761-2(b) for the procedures to follow. H&r block free tax return Partnership Return (Form 1065) Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. H&r block free tax return The partnership return must show the names and addresses of each partner and each partner's distributive share of taxable income. H&r block free tax return The return must be signed by a general partner. H&r block free tax return If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return. H&r block free tax return A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes. H&r block free tax return See the Instructions for Form 1065 for more information about who must file Form 1065. H&r block free tax return Partnership Distributions Partnership distributions include the following. H&r block free tax return A withdrawal by a partner in anticipation of the current year's earnings. H&r block free tax return A distribution of the current year's or prior years' earnings not needed for working capital. H&r block free tax return A complete or partial liquidation of a partner's interest. H&r block free tax return A distribution to all partners in a complete liquidation of the partnership. H&r block free tax return A partnership distribution is not taken into account in determining the partner's distributive share of partnership income or loss. H&r block free tax return If any gain or loss from the distribution is recognized by the partner, it must be reported on his or her return for the tax year in which the distribution is received. H&r block free tax return Money or property withdrawn by a partner in anticipation of the current year's earnings is treated as a distribution received on the last day of the partnership's tax year. H&r block free tax return Effect on partner's basis. H&r block free tax return   A partner's adjusted basis in his or her partnership interest is decreased (but not below zero) by the money and adjusted basis of property distributed to the partner. H&r block free tax return See Adjusted Basis under Basis of Partner's Interest, later. H&r block free tax return Effect on partnership. H&r block free tax return   A partnership generally does not recognize any gain or loss because of distributions it makes to partners. H&r block free tax return The partnership may be able to elect to adjust the basis of its undistributed property. H&r block free tax return Certain distributions treated as a sale or exchange. H&r block free tax return   When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property rather than a distribution. H&r block free tax return Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's interest in other partnership property, including money. H&r block free tax return Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or substantially appreciated inventory items. H&r block free tax return   See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. H&r block free tax return   This treatment does not apply to the following distributions. H&r block free tax return A distribution of property to the partner who contributed the property to the partnership. H&r block free tax return Payments made to a retiring partner or successor in interest of a deceased partner that are the partner's distributive share of partnership income or guaranteed payments. H&r block free tax return Substantially appreciated inventory items. H&r block free tax return   Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the distribution, their total fair market value is more than 120% of the partnership's adjusted basis for the property. H&r block free tax return However, if a principal purpose for acquiring inventory property is to avoid ordinary income treatment by reducing the appreciation to less than 120%, that property is excluded. H&r block free tax return Partner's Gain or Loss A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities treated as money) included in the distribution exceeds the adjusted basis of the partner's interest in the partnership. H&r block free tax return Any gain recognized is generally treated as capital gain from the sale of the partnership interest on the date of the distribution. H&r block free tax return If partnership property (other than marketable securities treated as money) is distributed to a partner, he or she generally does not recognize any gain until the sale or other disposition of the property. H&r block free tax return For exceptions to these rules, see Distribution of partner's debt and Net precontribution gain, later. H&r block free tax return Also, see Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later. H&r block free tax return Example. H&r block free tax return The adjusted basis of Jo's partnership interest is $14,000. H&r block free tax return She receives a distribution of $8,000 cash and land that has an adjusted basis of $2,000 and a fair market value of $3,000. H&r block free tax return Because the cash received does not exceed the basis of her partnership interest, Jo does not recognize any gain on the distribution. H&r block free tax return Any gain on the land will be recognized when she sells or otherwise disposes of it. H&r block free tax return The distribution decreases the adjusted basis of Jo's partnership interest to $4,000 [$14,000 − ($8,000 + $2,000)]. H&r block free tax return Marketable securities treated as money. H&r block free tax return   Generally, a marketable security distributed to a partner is treated as money in determining whether gain is recognized on the distribution. H&r block free tax return This treatment, however, does not generally apply if that partner contributed the security to the partnership or an investment partnership made the distribution to an eligible partner. H&r block free tax return   The amount treated as money is the security's fair market value when distributed, reduced (but not below zero) by the excess (if any) of: The partner's distributive share of the gain that would be recognized had the partnership sold all its marketable securities at their fair market value immediately before the transaction resulting in the distribution, over The partner's distributive share of the gain that would be recognized had the partnership sold all such securities it still held after the distribution at the fair market value in (1). H&r block free tax return   For more information, including the definition of marketable securities, see section 731(c) of the Internal Revenue Code. H&r block free tax return Loss on distribution. H&r block free tax return   A partner does not recognize loss on a partnership distribution unless all the following requirements are met. H&r block free tax return The adjusted basis of the partner's interest in the partnership exceeds the distribution. H&r block free tax return The partner's entire interest in the partnership is liquidated. H&r block free tax return The distribution is in money, unrealized receivables, or inventory items. H&r block free tax return   There are exceptions to these general rules. H&r block free tax return See the following discussions. H&r block free tax return Also, see Liquidation at Partner's Retirement or Death under Disposition of Partner's Interest, later. H&r block free tax return Distribution of partner's debt. H&r block free tax return   If a partnership acquires a partner's debt and extinguishes the debt by distributing it to the partner, the partner will recognize capital gain or loss to the extent the fair market value of the debt differs from the basis of the debt (determined under the rules discussed in Partner's Basis for Distributed Property, later). H&r block free tax return   The partner is treated as having satisfied the debt for its fair market value. H&r block free tax return If the issue price (adjusted for any premium or discount) of the debt exceeds its fair market value when distributed, the partner may have to include the excess amount in income as canceled debt. H&r block free tax return   Similarly, a deduction may be available to a corporate partner if the fair market value of the debt at the time of distribution exceeds its adjusted issue price. H&r block free tax return Net precontribution gain. H&r block free tax return   A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution. H&r block free tax return   The gain recognized is the lesser of the following amounts. H&r block free tax return The excess of: The fair market value of the property received in the distribution, over The adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below zero) by any money received in the distribution. H&r block free tax return The “net precontribution gain” of the partner. H&r block free tax return This is the net gain the partner would recognize if all the property contributed by the partner within 7 years of the distribution, and held by the partnership immediately before the distribution, were distributed to another partner, other than a partner who owns more than 50% of the partnership. H&r block free tax return For information about the distribution of contributed property to another partner, see Contribution of Property , under Transactions Between Partnership and Partners, later. H&r block free tax return   The character of the gain is determined by reference to the character of the net precontribution gain. H&r block free tax return This gain is in addition to any gain the partner must recognize if the money distributed is more than his or her basis in the partnership. H&r block free tax return For these rules, the term “money” includes marketable securities treated as money, as discussed earlier. H&r block free tax return Effect on basis. H&r block free tax return   The adjusted basis of the partner's interest in the partnership is increased by any net precontribution gain recognized by the partner. H&r block free tax return Other than for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. H&r block free tax return See Basis of Partner's Interest , later. H&r block free tax return   The partnership must adjust its basis in any property the partner contributed within 7 years of the distribution to reflect any gain that partner recognizes under this rule. H&r block free tax return Exceptions. H&r block free tax return   Any part of a distribution that is property the partner previously contributed to the partnership is not taken into account in determining the amount of the excess distribution or the partner's net precontribution gain. H&r block free tax return For this purpose, the partner's previously contributed property does not include a contributed interest in an entity to the extent its value is due to property contributed to the entity after the interest was contributed to the partnership. H&r block free tax return   Recognition of gain under this rule also does not apply to a distribution of unrealized receivables or substantially appreciated inventory items if the distribution is treated as a sale or exchange, as discussed earlier. H&r block free tax return Partner's Basis for Distributed Property Unless there is a complete liquidation of a partner's interest, the basis of property (other than money) distributed to the partner by a partnership is its adjusted basis to the partnership immediately before the distribution. H&r block free tax return However, the basis of the property to the partner cannot be more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction. H&r block free tax return Example 1. H&r block free tax return The adjusted basis of Emily's partnership interest is $30,000. H&r block free tax return She receives a distribution of property that has an adjusted basis of $20,000 to the partnership and $4,000 in cash. H&r block free tax return Her basis for the property is $20,000. H&r block free tax return Example 2. H&r block free tax return The adjusted basis of Steve's partnership interest is $10,000. H&r block free tax return He receives a distribution of $4,000 cash and property that has an adjusted basis to the partnership of $8,000. H&r block free tax return His basis for the distributed property is limited to $6,000 ($10,000 − $4,000, the cash he receives). H&r block free tax return Complete liquidation of partner's interest. H&r block free tax return   The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's interest in the partnership reduced by any money distributed to the partner in the same transaction. H&r block free tax return Partner's holding period. H&r block free tax return   A partner's holding period for property distributed to the partner includes the period the property was held by the partnership. H&r block free tax return If the property was contributed to the partnership by a partner, then the period it was held by that partner is also included. H&r block free tax return Basis divided among properties. H&r block free tax return   If the basis of property received is the adjusted basis of the partner's interest in the partnership (reduced by money received in the same transaction), it must be divided among the properties distributed to the partner. H&r block free tax return For property distributed after August 5, 1997, allocate the basis using the following rules. H&r block free tax return Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to each item equal to the partnership's adjusted basis in the item immediately before the distribution. H&r block free tax return If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. H&r block free tax return Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each property equal to the partnership's adjusted basis in the property immediately before the distribution. H&r block free tax return If the allocable basis exceeds the total of these assigned bases, increase the assigned bases by the amount of the excess. H&r block free tax return If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. H&r block free tax return Allocating a basis increase. H&r block free tax return   Allocate any basis increase required in rule (2), above, first to properties with unrealized appreciation to the extent of the unrealized appreciation. H&r block free tax return If the basis increase is less than the total unrealized appreciation, allocate it among those properties in proportion to their respective amounts of unrealized appreciation. H&r block free tax return Allocate any remaining basis increase among all the properties in proportion to their respective fair market values. H&r block free tax return Example. H&r block free tax return Eun's basis in her partnership interest is $55,000. H&r block free tax return In a distribution in liquidation of her entire interest, she receives properties A and B, neither of which is inventory or unrealized receivables. H&r block free tax return Property A has an adjusted basis to the partnership of $5,000 and a fair market value of $40,000. H&r block free tax return Property B has an adjusted basis to the partnership of $10,000 and a fair market value of $10,000. H&r block free tax return To figure her basis in each property, Eun first assigns bases of $5,000 to property A and $10,000 to property B (their adjusted bases to the partnership). H&r block free tax return This leaves a $40,000 basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned bases). H&r block free tax return She first allocates $35,000 to property A (its unrealized appreciation). H&r block free tax return The remaining $5,000 is allocated between the properties based on their fair market values. H&r block free tax return $4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is allocated to property B. H&r block free tax return Eun's basis in property A is $44,000 ($5,000 + $35,000 + $4,000) and her basis in property B is $11,000 ($10,000 + $1,000). H&r block free tax return Allocating a basis decrease. H&r block free tax return   Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier. H&r block free tax return Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. H&r block free tax return If the basis decrease is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of unrealized depreciation. H&r block free tax return Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased in (1)). H&r block free tax return Example. H&r block free tax return Armando's basis in his partnership interest is $20,000. H&r block free tax return In a distribution in liquidation of his entire interest, he receives properties C and D, neither of which is inventory or unrealized receivables. H&r block free tax return Property C has an adjusted basis to the partnership of $15,000 and a fair market value of $15,000. H&r block free tax return Property D has an adjusted basis to the partnership of $15,000 and a fair market value of $5,000. H&r block free tax return To figure his basis in each property, Armando first assigns bases of $15,000 to property C and $15,000 to property D (their adjusted bases to the partnership). H&r block free tax return This leaves a $10,000 basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable basis). H&r block free tax return He allocates the entire $10,000 to property D (its unrealized depreciation). H&r block free tax return Armando's basis in property C is $15,000 and his basis in property D is $5,000 ($15,000 − $10,000). H&r block free tax return Distributions before August 6, 1997. H&r block free tax return   For property distributed before August 6, 1997, allocate the basis using the following rules. H&r block free tax return Allocate the basis first to unrealized receivables and inventory items included in the distribution to the extent of the partnership's adjusted basis in those items. H&r block free tax return If the partnership's adjusted basis in those items exceeded the allocable basis, allocate the basis among the items in proportion to their adjusted bases to the partnership. H&r block free tax return Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership. H&r block free tax return Partner's interest more than partnership basis. H&r block free tax return   If the basis of a partner's interest to be divided in a complete liquidation of the partner's interest is more than the partnership's adjusted basis for the unrealized receivables and inventory items distributed, and if no other property is distributed to which the partner can apply the remaining basis, the partner has a capital loss to the extent of the remaining basis of the partnership interest. H&r block free tax return Special adjustment to basis. H&r block free tax return   A partner who acquired any part of his or her partnership interest in a sale or exchange or upon the death of another partner may be able to choose a special basis adjustment for property distributed by the partnership. H&r block free tax return To choose the special adjustment, the partner must have received the distribution within 2 years after acquiring the partnership interest. H&r block free tax return Also, the partnership must not have chosen the optional adjustment to basis when the partner acquired the partnership interest. H&r block free tax return   If a partner chooses this special basis adjustment, the partner's basis for the property distributed is the same as it would have been if the partnership had chosen the optional adjustment to basis. H&r block free tax return However, this assigned basis is not reduced by any depletion or depreciation that would have been allowed or allowable if the partnership had previously chosen the optional adjustment. H&r block free tax return   The choice must be made with the partner's tax return for the year of the distribution if the distribution includes any property subject to depreciation, depletion, or amortization. H&r block free tax return If the choice does not have to be made for the distribution year, it must be made with the return for the first year in which the basis of the distributed property is pertinent in determining the partner's income tax. H&r block free tax return   A partner choosing this special basis adjustment must attach a statement to his or her tax return that the partner chooses under section 732(d) of the Internal Revenue Code to adjust the basis of property received in a distribution. H&r block free tax return The statement must show the computation of the special basis adjustment for the property distributed and list the properties to which the adjustment has been allocated. H&r block free tax return Example. H&r block free tax return Chin Ho purchased a 25% interest in X partnership for $17,000 cash. H&r block free tax return At the time of the purchase, the partnership owned inventory having a basis to the partnership of $14,000 and a fair market value of $16,000. H&r block free tax return Thus, $4,000 of the $17,000 he paid was attributable to his share of inventory with a basis to the partnership of $3,500. H&r block free tax return Within 2 years after acquiring his interest, Chin Ho withdrew from the partnership and for his entire interest received cash of $1,500, inventory with a basis to the partnership of $3,500, and other property with a basis of $6,000. H&r block free tax return The value of the inventory received was 25% of the value of all partnership inventory. H&r block free tax return (It is immaterial whether the inventory he received was on hand when he acquired his interest. H&r block free tax return ) Since the partnership from which Chin Ho withdrew did not make the optional adjustment to basis, he chose to adjust the basis of the inventory received. H&r block free tax return His share of the partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference between the $16,000 fair market value of the inventory and its $14,000 basis to the partnership at the time he acquired his interest). H&r block free tax return The adjustment applies only for purposes of determining his new basis in the inventory, and not for purposes of partnership gain or loss on disposition. H&r block free tax return The total to be allocated among the properties Chin Ho received in the distribution is $15,500 ($17,000 basis of his interest − $1,500 cash received). H&r block free tax return His basis in the inventory items is $4,000 ($3,500 partnership basis + $500 special adjustment). H&r block free tax return The remaining $11,500 is allocated to his new basis for the other property he received. H&r block free tax return Mandatory adjustment. H&r block free tax return   A partner does not always have a choice of making this special adjustment to basis. H&r block free tax return The special adjustment to basis must be made for a distribution of property (whether or not within 2 years after the partnership interest was acquired) if all the following conditions existed when the partner received the partnership interest. H&r block free tax return The fair market value of all partnership property (other than money) was more than 110% of its adjusted basis to the partnership. H&r block free tax return If there had been a liquidation of the partner's interest immediately after it was acquired, an allocation of the basis of that interest under the general rules (discussed earlier under Basis divided among properties) would have decreased the basis of property that could not be depreciated, depleted, or amortized and increased the basis of property that could be. H&r block free tax return The optional basis adjustment, if it had been chosen by the partnership, would have changed the partner's basis for the property actually distributed. H&r block free tax return Required statement. H&r block free tax return   Generally, if a partner chooses a special basis adjustment and notifies the partnership, or if the partnership makes a distribution for which the special basis adjustment is mandatory, the partnership must provide a statement to the partner. H&r block free tax return The statement must provide information necessary for the partner to compute the special basis adjustment. H&r block free tax return Marketable securities. H&r block free tax return   A partner's basis in marketable securities received in a partnership distribution, as determined in the preceding discussions, is increased by any gain recognized by treating the securities as money. H&r block free tax return See Marketable securities treated as money under Partner's Gain or Loss, earlier. H&r block free tax return The basis increase is allocated among the securities in proportion to their respective amounts of unrealized appreciation before the basis increase. H&r block free tax return Transactions Between Partnership and Partners For certain transactions between a partner and his or her partnership, the partner is treated as not being a member of the partnership. H&r block free tax return These transactions include the following. H&r block free tax return Performing services for, or transferring property to, a partnership if: There is a related allocation and distribution to a partner, and The entire transaction, when viewed together, is properly characterized as occurring between the partnership and a partner not acting in the capacity of a partner. H&r block free tax return Transferring money or other property to a partnership if: There is a related transfer of money or other property by the partnership to the contributing partner or another partner, and The transfers together are properly characterized as a sale or exchange of property. H&r block free tax return Payments by accrual basis partnership to cash basis partner. H&r block free tax return   A partnership that uses an accrual method of accounting cannot deduct any business expense owed to a cash basis partner until the amount is paid. H&r block free tax return However, this rule does not apply to guaranteed payments made to a partner, which are generally deductible when accrued. H&r block free tax return Guaranteed Payments Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income. H&r block free tax return A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner. H&r block free tax return This treatment is for purposes of determining gross income and deductible business expenses only. H&r block free tax return For other tax purposes, guaranteed payments are treated as a partner's distributive share of ordinary income. H&r block free tax return Guaranteed payments are not subject to income tax withholding. H&r block free tax return The partnership generally deducts guaranteed payments on line 10 of Form 1065 as a business expense. H&r block free tax return They are also listed on Schedules K and K-1 of the partnership return. H&r block free tax return The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along with his or her distributive share of the partnership's other ordinary income. H&r block free tax return Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital expenses. H&r block free tax return Generally, organizational and syndication expenses are not deductible by the partnership. H&r block free tax return However, a partnership can elect to deduct a portion of its organizational expenses and amortize the remaining expenses (see Business start-up and organizational costs in the Instructions for Form 1065). H&r block free tax return Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on the partners' Schedule K-1 as guaranteed payments. H&r block free tax return Minimum payment. H&r block free tax return   If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the minimum payment is more than the partner's distributive share of the partnership income before taking into account the guaranteed payment. H&r block free tax return Example. H&r block free tax return Under a partnership agreement, Divya is to receive 30% of the partnership income, but not less than $8,000. H&r block free tax return The partnership has net income of $20,000. H&r block free tax return Divya's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). H&r block free tax return The guaranteed payment that can be deducted by the partnership is $2,000 ($8,000 − $6,000). H&r block free tax return Divya's income from the partnership is $8,000, and the remaining $12,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement. H&r block free tax return If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard to the guarantee, would have been greater than the guarantee. H&r block free tax return Self-employed health insurance premiums. H&r block free tax return   Premiums for health insurance paid by a partnership on behalf of a partner, for services as a partner, are treated as guaranteed payments. H&r block free tax return The partnership can deduct the payments as a business expense, and the partner must include them in gross income. H&r block free tax return However, if the partnership accounts for insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums. H&r block free tax return   A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf as an adjustment to income. H&r block free tax return The partner cannot deduct the premiums for any calendar month, or part of a month, in which the partner is eligible to participate in any subsidized health plan maintained by any employer of the partner, the partner's spouse, the partner's dependents, or any children under age 27 who are not dependents. H&r block free tax return For more information on the self-employed health insurance deduction, see chapter 6 in Publication 535. H&r block free tax return Including payments in partner's income. H&r block free tax return   Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends. H&r block free tax return Example 1. H&r block free tax return Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. H&r block free tax return Her distributive share of the partnership income is 10%. H&r block free tax return The partnership has $50,000 of ordinary income after deducting the guaranteed payment. H&r block free tax return She must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual income tax return for her tax year in which the partnership's tax year ends. H&r block free tax return Example 2. H&r block free tax return Lamont is a calendar year taxpayer who is a partner in a partnership. H&r block free tax return The partnership uses a fiscal year that ended January 31, 2013. H&r block free tax return Lamont received guaranteed payments from the partnership from February 1, 2012, until December 31, 2012. H&r block free tax return He must include these guaranteed payments in income for 2013 and report them on his 2013 income tax return. H&r block free tax return Payments resulting in loss. H&r block free tax return   If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report the full amount of the guaranteed payments as ordinary income. H&r block free tax return The partner separately takes into account his or her distributive share of the partnership loss, to the extent of the adjusted basis of the partner's partnership interest. H&r block free tax return Sale or Exchange of Property Special rules apply to a sale or exchange of property between a partnership and certain persons. H&r block free tax return Losses. H&r block free tax return   Losses will not be allowed from a sale or exchange of property (other than an interest in the partnership) directly or indirectly between a partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%. H&r block free tax return   If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than 50% of the capital or profits interests in each partnership, no deduction of a loss is allowed. H&r block free tax return   The basis of each partner's interest in the partnership is decreased (but not below zero) by the partner's share of the disallowed loss. H&r block free tax return   If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. H&r block free tax return If any gain from the sale of the property is not recognized because of this rule, the basis of each partner's interest in the partnership is increased by the partner's share of that gain. H&r block free tax return Gains. H&r block free tax return   Gains are treated as ordinary income in a sale or exchange of property directly or indirectly between a person and a partnership, or between two partnerships, if both of the following tests are met. H&r block free tax return More than 50% of the capital or profits interest in the partnership(s) is directly or indirectly owned by the same person(s). H&r block free tax return The property in the hands of the transferee immediately after the transfer is not a capital asset. H&r block free tax return Property that is not a capital asset includes accounts receivable, inventory, stock-in-trade, and depreciable or real property used in a trade or business. H&r block free tax return More than 50% ownership. H&r block free tax return   To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply. H&r block free tax return An interest directly or indirectly owned by, or for, a corporation, partnership, estate, or trust is considered to be owned proportionately by, or for, its shareholders, partners, or beneficiaries. H&r block free tax return An individual is considered to own the interest directly or indirectly owned by, or for, the individual's family. H&r block free tax return For this rule, “family” includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants. H&r block free tax return If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning that interest when rules (1) and (2) are applied. H&r block free tax return However, if a person is considered to own an interest using rule (2), that person is not treated as actually owning that interest in reapplying rule (2) to make another person the constructive owner. H&r block free tax return Example. H&r block free tax return Individuals A and B and Trust T are equal partners in Partnership ABT. H&r block free tax return A's husband, AH, is the sole beneficiary of Trust T. H&r block free tax return Trust T's partnership interest will be attributed to AH only for the purpose of further attributing the interest to A. H&r block free tax return As a result, A is a more-than-50% partner. H&r block free tax return This means that any deduction for losses on transactions between her and ABT will not be allowed, and gain from property that in the hands of the transferee is not a capital asset is treated as ordinary, rather than capital, gain. H&r block free tax return More information. H&r block free tax return   For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Publication 544. H&r block free tax return Contribution of Property Usually, neither the partner nor the partnership recognizes a gain or loss when property is contributed to the partnership in exchange for a partnership interest. H&r block free tax return This applies whether a partnership is being formed or is already operating. H&r block free tax return The partnership's holding period for the property includes the partner's holding period. H&r block free tax return The contribution of limited partnership interests in one partnership for limited partnership interests in another partnership qualifies as a tax-free contribution of property to the second partnership if the transaction is made for business purposes. H&r block free tax return The exchange is not subject to the rules explained later under Disposition of Partner's Interest. H&r block free tax return Disguised sales. H&r block free tax return   A contribution of money or other property to the partnership followed by a distribution of different property from the partnership to the partner is treated not as a contribution and distribution, but as a sale of property, if both of the following tests are met. H&r block free tax return The distribution would not have been made but for the contribution. H&r block free tax return The partner's right to the distribution does not depend on the success of partnership operations. H&r block free tax return   All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized as a sale. H&r block free tax return However, if the contribution and distribution occur within 2 years of each other, the transfers are presumed to be a sale unless the facts clearly indicate that the transfers are not a sale. H&r block free tax return If the contribution and distribution occur more than 2 years apart, the transfers are presumed not to be a sale unless the facts clearly indicate that the transfers are a sale. H&r block free tax return Form 8275 required. H&r block free tax return   A partner must attach Form 8275, Disclosure Statement, (or other statement) to his or her return if the partner contributes property to a partnership and, within 2 years (before or after the contribution), the partnership transfers money or other consideration to the partner. H&r block free tax return For exceptions to this requirement, see section 1. H&r block free tax return 707-3(c)(2) of the regulations. H&r block free tax return   A partnership must attach Form 8275 (or other statement) to its return if it distributes property to a partner, and, within 2 years (before or after the distribution), the partner transfers money or other consideration to the partnership. H&r block free tax return   Form 8275 must include the following information. H&r block free tax return A caption identifying the statement as a disclosure under section 707 of the Internal Revenue Code. H&r block free tax return A description of the transferred property or money, including its value. H&r block free tax return A description of any relevant facts in determining if the transfers are properly viewed as a disguised sale. H&r block free tax return See section 1. H&r block free tax return 707-3(b)(2) of the regulations for a description of the facts and circumstances considered in determining if the transfers are a disguised sale. H&r block free tax return Contribution to partnership treated as investment company. H&r block free tax return   Gain is recognized when property is contributed (in exchange for an interest in the partnership) to a partnership that would be treated as an investment company if it were incorporated. H&r block free tax return   A partnership is generally treated as an investment company if over 80% of the value of its assets is held for investment and consists of certain readily marketable items. H&r block free tax return These items include money, stocks and other equity interests in a corporation, and interests in regulated investment companies and real estate investment trusts. H&r block free tax return For more information, see section 351(e)(1) of the Internal Revenue Code and the related regulations. H&r block free tax return Whether a partnership is treated as an investment company under this test is ordinarily determined immediately after the transfer of property. H&r block free tax return   This rule applies to limited partnerships and general partnerships, regardless of whether they are privately formed or publicly syndicated. H&r block free tax return Contribution to foreign partnership. H&r block free tax return   A domestic partnership that contributed property after August 5, 1997, to a foreign partnership in exchange for a partnership interest may have to file Form 8865 if either of the following apply. H&r block free tax return Immediately after the contribution, the partnership owned, directly or indirectly, at least a 10% interest in the foreign partnership. H&r block free tax return The fair market value of the property contributed to the foreign partnership, when added to other contributions of property made to the partnership during the preceding 12-month period, is greater than $100,000. H&r block free tax return   The partnership may also have to file Form 8865, even if no contributions are made during the tax year, if it owns a 10% or more interest in a foreign partnership at any time during the year. H&r block free tax return See the form instructions for more information. H&r block free tax return Basis of contributed property. H&r block free tax return   If a partner contributes property to a partnership, the partnership's basis for determining depreciation, depletion, gain, or loss for the property is the same as the partner's adjusted basis for the property when it was contributed, increased by any gain recognized by the partner at the time of contribution. H&r block free tax return Allocations to account for built-in gain or loss. H&r block free tax return   The fair market value of property at the time it is contributed may be different from the partner's adjusted basis. H&r block free tax return The partnership must allocate among the partners any income, deduction, gain, or loss on the property in a manner that will account for the difference. H&r block free tax return This rule also applies to contributions of accounts payable and other accrued but unpaid items of a cash basis partner. H&r block free tax return   The partnership can use different allocation methods for different items of contributed property. H&r block free tax return A single reasonable method must be consistently applied to each item, and the overall method or combination of methods must be reasonable. H&r block free tax return See section 1. H&r block free tax return 704-3 of the regulations for allocation methods generally considered reasonable. H&r block free tax return   If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner. H&r block free tax return If contributed property is subject to depreciation or other cost recovery, the allocation of deductions for these items takes into account built-in gain or loss on the property. H&r block free tax return However, the total depreciation, depletion, gain, or loss allocated to partners cannot be more than the depreciation or depletion allowable to the partnership or the gain or loss realized by the partnership. H&r block free tax return Example. H&r block free tax return Areta and Sofia formed an equal partnership. H&r block free tax return Areta contributed $10,000 in cash to the partnership and Sofia contributed depreciable property with a fair market value of $10,000 and an adjusted basis of $4,000. H&r block free tax return The partnership's basis for depreciation is limited to the adjusted basis of the property in Sofia's hands, $4,000. H&r block free tax return In effect, Areta purchased an undivided one-half interest in the depreciable property with her contribution of $10,000. H&r block free tax return Assuming that the depreciation rate is 10% a year under the General Depreciation System (GDS), she would have been entitled to a depreciation deduction of $500 per year, based on her interest in the partnership, if the adjusted basis of the property equaled its fair market value when contributed. H&r block free tax return To simplify this example, the depreciation deductions are determined without regard to any first-year depreciation conventions. H&r block free tax return However, since the partnership is allowed only $400 per year of depreciation (10% of $4,000), no more than $400 can be allocated between the partners. H&r block free tax return The entire $400 must be allocated to Areta. H&r block free tax return Distribution of contributed property to another partner. H&r block free tax return   If a partner contributes property to a partnership and the partnership distributes the property to another partner within 7 years of the contribution, the contributing partner must recognize gain or loss on the distribution. H&r block free tax return   The recognized gain or loss is the amount the contributing partner would have recognized if the property had been sold for its fair market value when it was distributed. H&r block free tax return This amount is the difference between the property's basis and its fair market value at the time of contribution. H&r block free tax return The character of the gain or loss will be the same as the character of the gain or loss that would have resulted if the partnership had sold the property to the distributee partner. H&r block free tax return Appropriate adjustments must be made to the adjusted basis of the contributing partner's partnership interest and to the adjusted basis of the property distributed to reflect the recognized gain or loss. H&r block free tax return Disposition of certain contributed property. H&r block free tax return   The following rules determine the character of the partnership's gain or loss on a disposition of certain types of contributed property. H&r block free tax return Unrealized receivables. H&r block free tax return If the property was an unrealized receivable in the hands of the contributing partner, any gain or loss on its disposition by the partnership is ordinary income or loss. H&r block free tax return Unrealized receivables are defined later under Payments for Unrealized Receivables and Inventory Items. H&r block free tax return When reading the definition, substitute “partner” for “partnership. H&r block free tax return ” Inventory items. H&r block free tax return If the property was an inventory item in the hands of the contributing partner, any gain or loss on its disposition by the partnership within 5 years after the contribution is ordinary income or loss. H&r block free tax return Inventory items are defined later in Payments for Unrealized Receivables and Inventory Items. H&r block free tax return Capital loss property. H&r block free tax return If the property was a capital asset in the contributing partner's hands, any loss on its disposition by the partnership within 5 years after the contribution is a capital loss. H&r block free tax return The capital loss is limited to the amount by which the partner's adjusted basis for the property exceeded the property's fair market value immediately before the contribution. H&r block free tax return Substituted basis property. H&r block free tax return If the disposition of any of the property listed in (1), (2), or (3) is a nonrecognition transaction, these rules apply when the recipient of the property disposes of any substituted basis property (other than certain corporate stock) resulting from the transaction. H&r block free tax return Contribution of Services A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed. H&r block free tax return Capital interest. H&r block free tax return   A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership. H&r block free tax return This determination generally is made at the time of receipt of the partnership interest. H&r block free tax return The fair market value of such an interest received by a partner as compensation for services must generally be included in the partner's gross income in the first tax year in which the partner can transfer the interest or the interest is not subject to a substantial risk of forfeiture. H&r block free tax return The capital interest transferred as compensation for services is subject to the rules for restricted property discussed in Publication 525 under Employee Compensation. H&r block free tax return   The fair market value of an interest in partnership capital transferred to a partner as payment for services to the partnership is a guaranteed payment, discussed earlier. H&r block free tax return Profits interest. H&r block free tax return   A profits interest is a partnership interest other than a capital interest. H&r block free tax return If a person receives a profits interest for providing services to, or for the benefit of, a partnership in a partner capacity or in anticipation of being a partner, the receipt of such an interest is not a taxable event for the partner or the partnership. H&r block free tax return However, this does not apply in the following situations. H&r block free tax return The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease. H&r block free tax return Within 2 years of receipt, the partner disposes of the profits interest. H&r block free tax return The profits interest is a limited partnership interest in a publicly traded partnership. H&r block free tax return   A profits interest transferred as compensation for services is not subject to the rules for restricted property that apply to capital interests. H&r block free tax return Basis of Partner's Interest The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. H&r block free tax return If the partner must recognize gain as a result of the contribution, this gain is included in the basis of his or her interest. H&r block free tax return Any increase in a partner's individual liabilities because of an assumption of partnership liabilities is considered a contribution of money to the partnership by the partner. H&r block free tax return Interest acquired by gift, etc. H&r block free tax return   If a partner acquires an interest in a partnership by gift, inheritance, or under any circumstance other than by a contribution of money or property to the partnership, the partner's basis must be determined using the basis rules described in Publication 551. H&r block free tax return Adjusted Basis There is a worksheet for adjusting the basis of a partner's interest in the partnership in the Partner's Instructions for Schedule K-1 (Form 1065). H&r block free tax return The basis of an interest in a partnership is increased or decreased by certain items. H&r block free tax return Increases. H&r block free tax return   A partner's basis is increased by the following items. H&r block free tax return The partner's additional contributions to the partnership, including an increased share of, or assumption of, partnership liabilities. H&r block free tax return The partner's distributive share of taxable and nontaxable partnership income. H&r block free tax return The partner's distributive share of the excess of the deductions for depletion over the basis of the depletable property, unless the property is oil or gas wells whose basis has been allocated to partners. H&r block free tax return Decreases. H&r block free tax return   The partner's basis is decreased (but never below zero) by the following items. H&r block free tax return The money (including a decreased share of partnership liabilities or an assumption of the partner's individual liabilities by the partnership) and adjusted basis of property distributed to the partner by the partnership. H&r block free tax return The partner's distributive share of the partnership losses (including capital losses). H&r block free tax return The partner's distributive share of nondeductible partnership expenses that are not capital expenditures. H&r block free tax return This includes the partner's share of any section 179 expenses, even if the partner cannot deduct the entire amount on his or her individual income tax return. H&r block free tax return The partner's deduction for depletion for any partnership oil and gas wells, up to the proportionate share of the adjusted basis of the wells allocated to the partner. H&r block free tax return Partner's liabilities assumed by partnership. H&r block free tax return   If contributed property is subject to a debt or if a partner's liabilities are assumed by the partnership, the basis of that partner's interest is reduced (but not below zero) by the liability assumed by the other partners. H&r block free tax return This partner must reduce his or her basis because the assumption of the liability is treated as a distribution of money to that partner. H&r block free tax return The other partners' assumption of the liability is treated as a contribution by them of money to the partnership. H&r block free tax return See Effect of Partnership Liabilities , later. H&r block free tax return Example 1. H&r block free tax return Ivan acquired a 20% interest in a partnership by contributing property that had an adjusted basis to him of $8,000 and a $4,000 mortgage. H&r block free tax return The partnership assumed payment of the mortgage. H&r block free tax return The basis of Ivan's interest is: Adjusted basis of contributed property $8,000 Minus: Part of mortgage assumed by other partners (80% × $4,000) 3,200 Basis of Ivan's partnership interest $4,800 Example 2. H&r block free tax return If, in Example 1, the contributed property had a $12,000 mortgage, the basis of Ivan's partnership interest would be zero. H&r block free tax return The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership interest. H&r block free tax return However, this gain would not increase the basis of his partnership interest. H&r block free tax return Book value of partner's interest. H&r block free tax return   The adjusted basis of a partner's interest is determined without considering any amount shown in the partnership books as a capital, equity, or similar account. H&r block free tax return Example. H&r block free tax return Enzo contributes to his partnership property that has an adjusted basis of $400 and a fair market value of $1,000. H&r block free tax return His partner contributes $1,000 cash. H&r block free tax return While each partner has increased his capital account by $1,000, which will be re
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The H&r Block Free Tax Return

H&r block free tax return 4. H&r block free tax return   Unrelated Business Taxable Income Table of Contents IncomeExclusions Dues of Agricultural Organizations and Business Leagues DeductionsDirectly Connected Exploitation of Exempt Activity—Advertising Sales Modifications Partnership Income or Loss S Corporation Income or Loss Special Rules for Foreign Organizations Special Rules for Social Clubs, VEBAs, SUBs, and GLSOsIncome that is set aside. H&r block free tax return Special Rules for Veterans' Organizations Income From Controlled OrganizationsAddition to tax for valuation misstatements. H&r block free tax return Net unrelated income. H&r block free tax return Net unrelated loss. H&r block free tax return Control. H&r block free tax return Income from property financed with qualified 501(c)(3) bonds. H&r block free tax return Disposition of property received from taxable subsidiary and used in unrelated business. H&r block free tax return Income From Debt-Financed Property Debt-Financed PropertyAcquisition Indebtedness Computation of Debt-Financed Income Deductions for Debt-Financed Property Allocation Rules How to Get Tax Help The term “unrelated business taxable income” generally means the gross income derived from any unrelated trade or business regularly conducted by the exempt organization, less the deductions directly connected with carrying on the trade or business. H&r block free tax return If an organization regularly carries on two or more unrelated business activities, its unrelated business taxable income is the total of gross income from all such activities less the total allowable deductions attributable to all the activities. H&r block free tax return In computing unrelated business taxable income, gross income and deductions are subject to the modifications and special rules explained in this chapter. H&r block free tax return Whether a particular item of income or expense falls within any of these modifications or special rules must be determined by all the facts and circumstances in each specific case. H&r block free tax return For example, if the organization received a payment termed rent that is in fact a return of profits by a person operating the property for the benefit of the organization, or that is a share of the profits retained by the organization as a partner or joint venturer, the payment is not within the income exclusion for rents, discussed later under Exclusions. H&r block free tax return Income Generally, unrelated business income is taxable, but there are exclusions and special rules that must be considered when figuring the income. H&r block free tax return Exclusions The following types of income (and deductions directly connected with the income) are generally excluded when figuring unrelated business taxable income. H&r block free tax return Dividends, interest, annuities and other investment income. H&r block free tax return   All dividends, interest, annuities, payments with respect to securities loans, income from notional principal contracts, and other income from an exempt organization's ordinary and routine investments that the IRS determines are substantially similar to these types of income are excluded in computing unrelated business taxable income. H&r block free tax return Exception for insurance activity income of a controlled foreign corporation. H&r block free tax return   This exclusion does not apply to income from certain insurance activities of an exempt organization's controlled foreign corporation. H&r block free tax return The income is not excludable dividend income, but instead is unrelated business taxable income to the extent it would be so treated if the exempt organization had earned it directly. H&r block free tax return Certain exceptions to this rule apply. H&r block free tax return For more information, see section 512(b)(17). H&r block free tax return Other exceptions. H&r block free tax return   This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later), to interest or annuities received from a controlled corporation (discussed under Income From Controlled Organizations, later). H&r block free tax return Income from lending securities. H&r block free tax return   Payments received with respect to a security loan are excluded in computing unrelated business taxable income only if the loan is made under an agreement that:    Provides for the return to the exempt organization of securities identical to the securities loaned, Requires payments to the organization of amounts equivalent to all interest, dividends, and other distributions that the owner of the securities is entitled to receive during the period of the loan, Does not reduce the organization's risk of loss or opportunity for gain on the securities, Contains reasonable procedures to implement the obligation of the borrower to furnish collateral to the organization with a fair market value each business day during the period of the loan in an amount not less than the fair market value of the securities at the close of the preceding business day, and Permits the organization to terminate the loan upon notice of not more than 5 business days. H&r block free tax return   Payments with respect to securities loans include: Amounts in respect of dividends, interest, and other distributions, Fees based on the period of time the loan is in effect and the fair market value of the security during that period, Income from collateral security for the loan, and Income from the investment of collateral security. H&r block free tax return The payments are considered to be from the securities loaned and not from collateral security or the investment of collateral security from the loans. H&r block free tax return Any deductions that are directly connected with collateral security for the loan, or with the investment of collateral security, are considered deductions that are directly connected with the securities loaned. H&r block free tax return Royalties. H&r block free tax return   Royalties, including overriding royalties, are excluded in computing unrelated business taxable income. H&r block free tax return   To be considered a royalty, a payment must relate to the use of a valuable right. H&r block free tax return Payments for trademarks, trade names, or copyrights are ordinarily considered royalties. H&r block free tax return Similarly, payments for the use of a professional athlete's name, photograph, likeness, or facsimile signature are ordinarily considered royalties. H&r block free tax return However, royalties do not include payments for personal services. H&r block free tax return Therefore, payments for personal appearances and interviews are not excluded as royalties and must be included in figuring unrelated business taxable income. H&r block free tax return   Unrelated business taxable income does not include royalty income received from licensees by an exempt organization that is the legal and beneficial owner of patents assigned to it by inventors for specified percentages of future royalties. H&r block free tax return   Mineral royalties are excluded whether measured by production or by gross or taxable income from the mineral property. H&r block free tax return However, the exclusion does not apply to royalties that stem from an arrangement whereby the organization owns a working interest in a mineral property and is liable for its share of the development and operating costs under the terms of its agreement with the operator of the property. H&r block free tax return To the extent they are not treated as loans under section 636 (relating to income tax treatment of mineral production payments), payments for mineral production are treated in the same manner as royalty payments for the purpose of computing unrelated business taxable income. H&r block free tax return To the extent they are treated as loans, any payments for production that are the equivalent of interest are treated as interest and are excluded. H&r block free tax return Exceptions. H&r block free tax return   This exclusion does not apply to debt-financed income (discussed under Income From Debt-Financed Property, later) or to royalties received from a controlled corporation (discussed under Income From Controlled Organizations, later). H&r block free tax return Rents. H&r block free tax return   Rents from real property, including elevators and escalators, are excluded in computing unrelated business taxable income. H&r block free tax return Rents from personal property are not excluded. H&r block free tax return However, special rules apply to “mixed leases” of both real and personal property. H&r block free tax return Mixed leases. H&r block free tax return   In a mixed lease, all of the rents are excluded if the rents attributable to the personal property are not more than 10% of the total rents under the lease, as determined when the personal property is first placed in service by the lessee. H&r block free tax return If the rents attributable to personal property are more than 10% but not more than 50% of the total rents, only the rents attributable to the real property are excluded. H&r block free tax return If the rents attributable to the personal property are more than 50% of the total rents, none of the rents are excludable. H&r block free tax return   Property is placed in service when the lessee first may use it under the terms of a lease. H&r block free tax return For example, property subject to a lease entered into on November 1, for a term starting on January 1 of the next year, is considered placed in service on January 1, regardless of when the lessee first actually uses it. H&r block free tax return   If separate leases are entered into for real and personal property and the properties have an integrated use (for example, one or more leases for real property and another lease or leases for personal property to be used on the real property), all the leases will be considered as one lease. H&r block free tax return   The rent attributable to the personal property must be recomputed, and the treatment of the rents must be redetermined, if: The rent attributable to all the leased personal property increases by 100% or more because additional or substitute personal property is placed in service, or The lease is modified to change the rent charged (whether or not the amount of rented personal property changes). H&r block free tax return Any change in the treatment of rents resulting from the recomputation is effective only for the period beginning with the event that caused the recomputation. H&r block free tax return Exception for rents based on net profit. H&r block free tax return   The exclusion for rents does not apply if the amount of the rent depends on the income or profits derived by any person from the leased property, other than an amount based on a fixed percentage of the gross receipts or sales. H&r block free tax return Exception for income from personal services. H&r block free tax return   Payment for occupying space when personal services are also rendered to the occupant does not constitute rent from real property. H&r block free tax return Therefore, the exclusion does not apply to transactions such as renting hotel rooms, rooms in boarding houses or tourist homes, and space in parking lots or warehouses. H&r block free tax return Other exceptions. H&r block free tax return   This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later), or to interest, annuities, royalties and rents received from a controlled corporation (discussed under Income From Controlled Organizations, later), investment income (dividends, interest, rents, etc. H&r block free tax return ) received by organizations described in sections 501(c)(7), 501(c)(9), 501(c)(17), and 501(c)(20). H&r block free tax return See Special Rules for Social Clubs, VEBAs, SUBs, and GLSOs, discussed later for more information. H&r block free tax return Income from research. H&r block free tax return   A tax-exempt organization may exclude income from research grants or contracts from unrelated business taxable income. H&r block free tax return However, the extent of the exclusion depends on the nature of the organization and the type of research. H&r block free tax return   Income from research for the United States, any of its agencies or instrumentalities, or a state or any of its political subdivisions is excluded when computing unrelated business taxable income. H&r block free tax return   For a college, university, or hospital, all income from research, whether fundamental or applied, is excluded in computing unrelated business taxable income. H&r block free tax return   When an organization is operated primarily to conduct fundamental research (as distinguished from applied research) and the results are freely available to the general public, all income from research performed for any person is excluded in computing unrelated business taxable income. H&r block free tax return   The term research, for this purpose, does not include activities of a type normally conducted as an incident to commercial or industrial operations, such as testing or inspecting materials or products, or designing or constructing equipment, buildings, etc. H&r block free tax return In addition, the term fundamental research does not include research conducted for the primary purpose of commercial or industrial application. H&r block free tax return Gains and losses from disposition of property. H&r block free tax return   Also excluded from unrelated business taxable income are gains or losses from the sale, exchange, or other disposition of property other than: Stock in trade or other property of a kind that would properly be includable in inventory if on hand at the close of the tax year, Property held primarily for sale to customers in the ordinary course of a trade or business, or Cutting of timber that an organization has elected to consider as a sale or exchange of the timber. H&r block free tax return   It should be noted that the last exception relates only to cut timber. H&r block free tax return The sale, exchange, or other disposition of standing timber is excluded from the computation of unrelated business income, unless it constitutes property held for sale to customers in the ordinary course of business. H&r block free tax return Lapse or termination of options. H&r block free tax return   Any gain from the lapse or termination of options to buy or sell securities is excluded from unrelated business taxable income. H&r block free tax return The exclusion applies only if the option is written in connection with the exempt organization's investment activities. H&r block free tax return Therefore, this exclusion is not available if the organization is engaged in the trade or business of writing options or the options are held by the organization as inventory or for sale to customers in the ordinary course of a trade or business. H&r block free tax return Exception. H&r block free tax return   This exclusion does not apply to unrelated debt-financed income, discussed later under Income From Debt-Financed Property. H&r block free tax return Gain or loss on disposition of certain brownfield property. H&r block free tax return   Gain or loss from the qualifying sale, exchange, or other disposition of a qualifying brownfield property (as defined in section 512(b)(19)(C)), which was acquired by the organization after December 31, 2005 and before January 1, 2011, is excluded from unrelated business taxable income and is excepted from the debt-financed rules for such property. H&r block free tax return See sections 512(b)(19) and 514(b)(1)(E). H&r block free tax return Income from services provided under federal license. H&r block free tax return   There is a further exclusion from unrelated business taxable income of income from a trade or business conducted by a religious order or by an educational organization maintained by the order. H&r block free tax return   This exclusion applies only if the following requirements are met. H&r block free tax return The trade or business must have been operated by the order or by the institution before May 27, 1959. H&r block free tax return The trade or business must provide services under a license issued by a federal regulatory agency. H&r block free tax return More than 90% of the net income from the business for the tax year must be devoted to religious, charitable, or educational purposes that constitute the basis for the religious order's exemption. H&r block free tax return The rates or other charges for these services must be fully competitive with the rates or other charges of similar taxable businesses. H&r block free tax return Rates or other charges for these services will be considered as fully competitive if they are neither materially higher nor materially lower than the rates charged by similar businesses operating in the same general area. H&r block free tax return Exception. H&r block free tax return    This exclusion does not apply to unrelated debt-financed income (discussed under Income From Debt-Financed Property, later). H&r block free tax return Member income of mutual or cooperative electric companies. H&r block free tax return   Income of a mutual or cooperative electric company described in section 501(c)(12) which is treated as member income under subparagraph (H) of that section is excluded from unrelated business taxable income. H&r block free tax return Dues of Agricultural Organizations and Business Leagues Dues received from associate members by organizations exempt under section 501(c)(5) or section 501(c)(6) may be treated as gross income from an unrelated trade or business if the associate member category exists for the principal purpose of producing unrelated business income. H&r block free tax return For example, if an organization creates an associate member category solely to allow associate members to purchase insurance through the organization, the associate member dues may be unrelated business income. H&r block free tax return Exception. H&r block free tax return   Associate member dues received by an agricultural or horticultural organization are not treated as gross income from an unrelated trade or business, regardless of their purpose, if they are not more than the annual limit. H&r block free tax return The limit on dues paid by an associate member is $148 for 2011. H&r block free tax return   If the required annual dues are more than the limit, the entire amount is treated as income from an unrelated business unless the associate member category was formed or availed of for the principal purpose of furthering the organization's exempt purposes. H&r block free tax return Deductions To qualify as allowable deductions in computing unrelated business taxable income, the expenses, depreciation, and similar items generally must be allowable income tax deductions that are directly connected with carrying on an unrelated trade or business. H&r block free tax return They cannot be directly connected with excluded income. H&r block free tax return For an exception to the “directly connected” requirement, see Charitable contributions deduction, under Modifications, later. H&r block free tax return Directly Connected To be directly connected with the conduct of an unrelated business, deductions must have a proximate and primary relationship to carrying on that business. H&r block free tax return For an exception, see Expenses attributable to exploitation of exempt activities, later. H&r block free tax return Expenses attributable solely to unrelated business. H&r block free tax return   Expenses, depreciation, and similar items attributable solely to the conduct of an unrelated business are proximately and primarily related to that business and qualify for deduction to the extent that they are otherwise allowable income tax deductions. H&r block free tax return   For example, salaries of personnel employed full-time to conduct the unrelated business and depreciation of a building used entirely in the conduct of that business are deductible to the extent otherwise allowable. H&r block free tax return Expenses attributable to dual use of facilities or personnel. H&r block free tax return   When facilities or personnel are used both to conduct exempt functions and to conduct an unrelated trade or business, expenses, depreciation, and similar items attributable to the facilities or personnel must be allocated between the two uses on a reasonable basis. H&r block free tax return The part of an item allocated to the unrelated trade or business is proximately and primarily related to that business and is allowable as a deduction in computing unrelated business taxable income if the expense is otherwise an allowable income tax deduction. H&r block free tax return Example 1. H&r block free tax return A school recognized as a tax-exempt organization contracts with an individual to conduct a summer tennis camp. H&r block free tax return The school provides the tennis courts, housing, and dining facilities. H&r block free tax return The contracted individual hires the instructors, recruits campers, and provides supervision. H&r block free tax return The income the school receives from this activity is from a dual use of the facilities and personnel. H&r block free tax return The school, in computing its unrelated business taxable income, may deduct an allocable part of the expenses attributable to the facilities and personnel. H&r block free tax return Example 2. H&r block free tax return An exempt organization with gross income from an unrelated trade or business pays its president $90,000 a year. H&r block free tax return The president devotes approximately 10% of his time to the unrelated business. H&r block free tax return To figure the organization's unrelated business taxable income, a deduction of $9,000 ($90,000 × 10%) is allowed for the salary paid to its president. H&r block free tax return Expenses attributable to exploitation of exempt activities. H&r block free tax return   Generally, expenses, depreciation, and similar items attributable to the conduct of an exempt activity are not deductible in computing unrelated business taxable income from an unrelated trade or business that exploits the exempt activity. H&r block free tax return (See Exploitation of exempt functions under Not substantially related in chapter 3. H&r block free tax return ) This is because they do not have a proximate and primary relationship to the unrelated trade or business, and therefore, they do not qualify as directly connected with that business. H&r block free tax return Exception. H&r block free tax return   Expenses, depreciation, and similar items may be treated as directly connected with the conduct of the unrelated business if all the following statements are true. H&r block free tax return The unrelated business exploits the exempt activity. H&r block free tax return The unrelated business is a type normally conducted for profit by taxable organizations. H&r block free tax return The exempt activity is a type normally conducted by taxable organizations in carrying on that type of business. H&r block free tax return The amount treated as directly connected is the smaller of: The excess of these expenses, depreciation, and similar items over the income from, or attributable to, the exempt activity; or The gross unrelated business income reduced by all other expenses, depreciation, and other items that are actually directly connected. H&r block free tax return   The application of these rules to an advertising activity that exploits an exempt publishing activity is explained next. H&r block free tax return Exploitation of Exempt Activity—Advertising Sales The sale of advertising in a periodical of an exempt organization that contains editorial material related to the accomplishment of the organization's exempt purpose is an unrelated business that exploits an exempt activity, the circulation and readership of the periodical. H&r block free tax return Therefore, in addition to direct advertising costs, exempt activity costs (expenses, depreciation, and similar expenses attributable to the production and distribution of the editorial or readership content) can be treated as directly connected with the conduct of the advertising activity. H&r block free tax return (See Expenses attributable to exploitation of exempt activities under Directly Connected, earlier. H&r block free tax return ) Figuring unrelated business taxable income (UBTI). H&r block free tax return   The UBTI of an advertising activity is the amount shown in the following chart. H&r block free tax return IF gross advertising income is . H&r block free tax return . H&r block free tax return . H&r block free tax return THEN UBTI is . H&r block free tax return . H&r block free tax return . H&r block free tax return More than direct advertising costs The excess advertising income, reduced (but not below zero) by the excess, if any, of readership costs over circulation income. H&r block free tax return Equal to or less than direct advertising costs Zero. H&r block free tax return   • Circulation income and readership costs are not taken into account. H&r block free tax return   • Any excess advertising costs reduce (but not below zero) UBTI from any other unrelated business activity. H&r block free tax return   The terms used in the chart are explained in the following discussions. H&r block free tax return Periodical Income Gross advertising income. H&r block free tax return   This is all the income from the unrelated advertising activities of an exempt organization periodical. H&r block free tax return Circulation income. H&r block free tax return   This is all the income from the production, distribution, or circulation of an exempt organization's periodical (other than gross advertising income). H&r block free tax return It includes all amounts from the sale or distribution of the readership content of the periodical, such as income from subscriptions. H&r block free tax return It also includes allocable membership receipts if the right to receive the periodical is associated with a membership or similar status in the organization. H&r block free tax return Allocable membership receipts. H&r block free tax return   This is the part of membership receipts (dues, fees, or other charges associated with membership) equal to the amount that would have been charged and paid for the periodical if: The periodical was published by a taxable organization, The periodical was published for profit, and The member was an unrelated party dealing with the taxable organization at arm's length. H&r block free tax return   The amount used to allocate membership receipts is the amount shown in the following chart. H&r block free tax return   For this purpose, the total periodical costs are the sum of the direct advertising costs and the readership costs, explained under Periodical Costs, later. H&r block free tax return The cost of other exempt activities means the total expenses incurred by the organization in connection with its other exempt activities, not offset by any income earned by the organization from those activities. H&r block free tax return IF . H&r block free tax return . H&r block free tax return . H&r block free tax return THEN the amount used to allocate membership receipts is . H&r block free tax return . H&r block free tax return . H&r block free tax return 20% or more of the total circulation consists of sales to nonmembers The subscription price charged nonmembers. H&r block free tax return The above condition does not apply, and 20% or more of the members pay reduced dues because they do not receive the periodical The reduction in dues for a member not receiving the periodical. H&r block free tax return Neither of the above conditions applies The membership receipts multiplied by this fraction:   Total periodical costs Total periodical costs Plus Cost of other exempt activities Example 1. H&r block free tax return U is an exempt scientific organization with 10,000 members who pay annual dues of $15. H&r block free tax return One of U's activities is publishing a monthly periodical distributed to all of its members. H&r block free tax return U also distributes 5,000 additional copies of its periodical to nonmembers, who subscribe for $10 a year. H&r block free tax return Since the nonmember circulation of U's periodical represents one-third (more than 20%) of its total circulation, the subscription price charged to nonmembers is used to determine the part of U's membership receipts allocable to the periodical. H&r block free tax return Thus, U's allocable membership receipts are $100,000 ($10 times 10,000 members), and U's total circulation income for the periodical is $150,000 ($100,000 from members plus $50,000 from sales to nonmembers). H&r block free tax return Example 2. H&r block free tax return Assume the same facts except that U sells only 500 copies of its periodical to nonmembers, at a price of $10 a year. H&r block free tax return Assume also that U's members may elect not to receive the periodical, in which case their dues are reduced from $15 a year to $6 a year, and that only 3,000 members elect to receive the periodical and pay the full dues of $15 a year. H&r block free tax return U's stated subscription price of $9 to members consistently results in an excess of total income (including gross advertising income) attributable to the periodical over total costs of the periodical. H&r block free tax return Since the 500 copies of the periodical distributed to nonmembers represent only 14% of the 3,500 copies distributed, the $10 subscription price charged to nonmembers is not used to determine the part of membership receipts allocable to the periodical. H&r block free tax return Instead, since 70% of the members elect not to receive the periodical and pay $9 less per year in dues, the $9 price is used to determine the subscription price charged to members. H&r block free tax return Thus, the allocable membership receipts will be $9 a member, or $27,000 ($9 times 3,000 copies). H&r block free tax return U's total circulation income is $32,000 ($27,000 plus the $5,000 from nonmember subscriptions). H&r block free tax return Periodical Costs Direct advertising costs. H&r block free tax return   These are expenses, depreciation, and similar items of deduction directly connected with selling and publishing advertising in the periodical. H&r block free tax return   Examples of allowable deductions under this classification include agency commissions and other direct selling costs, such as transportation and travel expenses, office salaries, promotion and research expenses, and office overhead directly connected with the sale of advertising lineage in the periodical. H&r block free tax return Also included are other deductions commonly classified as advertising costs under standard account classifications, such as artwork and copy preparation, telephone, telegraph, postage, and similar costs directly connected with advertising. H&r block free tax return   In addition, direct advertising costs include the part of mechanical and distribution costs attributable to advertising lineage. H&r block free tax return For this purpose, the general account classifications of items includable in mechanical and distribution costs ordinarily employed in business-paper and consumer-publication accounting provide a guide for the computation. H&r block free tax return Accordingly, the mechanical and distribution costs include the part of the costs and other expenses of composition, press work, binding, mailing (including paper and wrappers used for mailing), and bulk postage attributable to the advertising lineage of the publication. H&r block free tax return   In the absence of specific and detailed records, the part of mechanical and distribution costs attributable to the periodical's advertising lineage can be based on the ratio of advertising lineage to total lineage in the periodical, if this allocation is reasonable. H&r block free tax return Readership costs. H&r block free tax return   These are all expenses, depreciation, and similar items that are directly connected with the production and distribution of the readership content of the periodical. H&r block free tax return Costs partly attributable to other activities. H&r block free tax return   Deductions properly attributable to exempt activities other than publishing the periodical may not be allocated to the periodical. H&r block free tax return When expenses are attributable both to the periodical and to the organization's other activities, an allocation must be made on a reasonable basis. H&r block free tax return The method of allocation will vary with the nature of the item, but once adopted, should be used consistently. H&r block free tax return Allocations based on dollar receipts from various exempt activities generally are not reasonable since receipts usually do not accurately reflect the costs associated with specific activities that an exempt organization conducts. H&r block free tax return Consolidated Periodicals If an exempt organization publishes more than one periodical to produce income, it may treat all of them (but not less than all) as one in determining unrelated business taxable income from selling advertising. H&r block free tax return It treats the gross income from all the periodicals, and the deductions directly connected with them, on a consolidated basis. H&r block free tax return Consolidated treatment, once adopted, must be followed consistently and is binding. H&r block free tax return This treatment can be changed only with the consent of the Internal Revenue Service. H&r block free tax return An exempt organization's periodical is published to produce income if: The periodical generates gross advertising income to the organization equal to at least 25% of its readership costs, and Publishing the periodical is an activity engaged in for profit. H&r block free tax return Whether the publication of a periodical is an activity engaged in for profit can be determined only by all the facts and circumstances in each case. H&r block free tax return The facts and circumstances must show that the organization carries on the activity for economic profit, although there may not be a profit in a particular year. H&r block free tax return For example, if an organization begins publishing a new periodical whose total costs exceed total income in the start-up years because of lack of advertising sales, that does not mean that the organization did not have as its objective an economic profit. H&r block free tax return The organization may establish that it had this objective by showing it can reasonably expect advertising sales to increase, so that total income will exceed costs within a reasonable time. H&r block free tax return Example. H&r block free tax return Y, an exempt trade association, publishes three periodicals that it distributes to its members: a weekly newsletter, a monthly magazine, and a quarterly journal. H&r block free tax return Both the monthly magazine and the quarterly journal contain advertising that accounts for gross advertising income equal to more than 25% of their respective readership costs. H&r block free tax return Similarly, the total income attributable to each periodical has exceeded the total deductions attributable to each periodical for substantially all the years they have been published. H&r block free tax return The newsletter carries no advertising and its annual subscription price is not intended to cover the cost of publication. H&r block free tax return The newsletter is a service that Y distributes to all of its members in an effort to keep them informed of changes occurring in the business world. H&r block free tax return It is not engaged in for profit. H&r block free tax return Under these circumstances, Y may consolidate the income and deductions from the monthly and quarterly journals in computing its unrelated business taxable income. H&r block free tax return It may not consolidate the income and deductions from the newsletter with the income and deductions of its other periodicals, since the newsletter is not published for the production of income. H&r block free tax return Modifications Net operating loss deduction. H&r block free tax return   The net operating loss (NOL) deduction (as provided in section 172) is allowed in computing unrelated business taxable income. H&r block free tax return However, the NOL for any tax year, the carrybacks and carryovers of NOLs, and the NOL deduction are determined without taking into account any amount of income or deduction that has been specifically excluded in computing unrelated business taxable income. H&r block free tax return For example, a loss from an unrelated trade or business is not diminished because dividend income was received. H&r block free tax return   If this were not done, organizations would, in effect, be taxed on their exempt income, since unrelated business losses then would be offset by dividends, interest, and other excluded income. H&r block free tax return This would reduce the loss that could be applied against unrelated business income of prior or future tax years. H&r block free tax return Therefore, to preserve the immunity of exempt income, all NOL computations are limited to those items of income and deductions that affect the unrelated business taxable income. H&r block free tax return   In line with this concept, an NOL carryback or carryover is allowed only from a tax year for which the organization is subject to tax on unrelated business income. H&r block free tax return   For example, if an organization just became subject to the tax last year, its NOL for that year is not a carryback to a prior year when it had no unrelated business taxable income, nor is its NOL carryover to succeeding years reduced by the related income of those prior years. H&r block free tax return   However, in determining the span of years for which an NOL may be carried back or forward, the tax years for which the organization is not subject to the tax on unrelated business income are counted. H&r block free tax return For example, if an organization was subject to the tax for 2009 and had an NOL for that year, the last tax year to which any part of that loss may be carried over is 2029, regardless of whether the organization was subject to the unrelated business income tax in any of the intervening years. H&r block free tax return   For more details on the NOL deduction, including property eligible for an extended carryback period, see sections 172 and 1400N, Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, and Publication 4492-B, Information for Affected Taxpayers in the Midwestern Disaster Areas. H&r block free tax return Charitable contributions deduction. H&r block free tax return   An exempt organization is allowed to deduct its charitable contributions in computing its unrelated business taxable income whether or not the contributions are directly connected with the unrelated business. H&r block free tax return   To be deductible, the contribution must be paid to another qualified organization. H&r block free tax return For example, an exempt university that operates an unrelated business may deduct a contribution made to another university for educational work, but may not claim a deduction for contributions of amounts spent for carrying out its own educational program. H&r block free tax return   For purposes of the deduction, a distribution by a trust made under the trust instrument to a beneficiary, which itself is a qualified organization, is treated the same as a contribution. H&r block free tax return Deduction limits. H&r block free tax return   An exempt organization that is subject to the unrelated business income tax at corporate rates is allowed a deduction for charitable contributions up to 10% of its unrelated business taxable income computed without regard to the deduction for contributions. H&r block free tax return See the Instructions for Form 990-T for more information. H&r block free tax return    An exempt trust that is subject to the unrelated business income tax at trust rates generally is allowed a deduction for charitable contributions in the same amounts as allowed for individuals. H&r block free tax return However, the limit on the deduction is determined in relation to the trust's unrelated business taxable income computed without regard to the deduction, rather than in relation to adjusted gross income. H&r block free tax return   Contributions in excess of the limits just described may be carried over to the next 5 tax years. H&r block free tax return A contribution carryover is not allowed, however, to the extent that it increases an NOL carryover. H&r block free tax return Suspension of deduction limits for farmers and ranchers. H&r block free tax return   The limitations discussed above are temporarily suspended for certain qualified conservation contributions of property used in agriculture or livestock production. H&r block free tax return See the Instructions for Form 990-T for details. H&r block free tax return Specific deduction. H&r block free tax return   In computing unrelated business taxable income, a specific deduction of $1,000 is allowed. H&r block free tax return However, the specific deduction is not allowed in computing an NOL or the NOL deduction. H&r block free tax return   Generally, the deduction is limited to $1,000 regardless of the number of unrelated businesses in which the organization is engaged. H&r block free tax return Exception. H&r block free tax return   An exception is provided in the case of a diocese, province of a religious order, or a convention or association of churches that may claim a specific deduction for each parish, individual church, district, or other local unit. H&r block free tax return In these cases, the specific deduction for each local unit is limited to the lower of: $1,000, or Gross income derived from an unrelated trade or business regularly conducted by the local unit. H&r block free tax return   This exception applies only to parishes, districts, or other local units that are not separate legal entities, but are components of a larger entity (diocese, province, convention, or association) filing Form 990-T. H&r block free tax return The parent organization must file a return reporting the unrelated business gross income and related deductions of all units that are not separate legal entities. H&r block free tax return The local units cannot file separate returns. H&r block free tax return However, each local unit that is separately incorporated must file its own return and cannot include, or be included with, any other entity. H&r block free tax return See Title-holding corporations in chapter 1 for a discussion of the only situation in which more than one legal entity may be included on the same Form 990-T. H&r block free tax return Example. H&r block free tax return X is an association of churches and is divided into local units A, B, C, and D. H&r block free tax return Last year, A, B, C, and D derived gross income of, respectively, $1,200, $800, $1,500, and $700 from unrelated businesses that they regularly conduct. H&r block free tax return X may claim a specific deduction of $1,000 with respect to A, $800 with respect to B, $1,000 with respect to C, and $700 with respect to D. H&r block free tax return Partnership Income or Loss An organization may have unrelated business income or loss as a member of a partnership, rather than through direct business dealings with the public. H&r block free tax return If so, it must treat its share of the partnership income or loss as if it had conducted the business activity in its own capacity as a corporation or trust. H&r block free tax return No distinction is made between limited and general partners. H&r block free tax return The organization is required to notify the partnership of its tax-exempt status. H&r block free tax return Thus, if an organization is a member of a partnership regularly engaged in a trade or business that is an unrelated trade or business with respect to the organization, the organization must include in its unrelated business taxable income its share of the partnership's gross income from the unrelated trade or business (whether or not distributed), and the deductions attributable to it. H&r block free tax return The partnership income and deductions to be included in the organization's unrelated business taxable income are figured the same way as any income and deductions from an unrelated trade or business conducted directly by the organization. H&r block free tax return The partnership is required to provide the organization this information on Schedule K-1. H&r block free tax return Example. H&r block free tax return An exempt educational organization is a partner in a partnership that operates a factory. H&r block free tax return The partnership also holds stock in a corporation. H&r block free tax return The exempt organization must include its share of the gross income from operating the factory in its unrelated business taxable income but may exclude its share of any dividends the partnership received from the corporation. H&r block free tax return Different tax years. H&r block free tax return   If the exempt organization and the partnership of which it is a member have different tax years, the partnership items that enter into the computation of the organization's unrelated business taxable income must be based on the income and deductions of the partnership for the partnership's tax year that ends within or with the organization's tax year. H&r block free tax return S Corporation Income or Loss An organization that owns S corporation stock must take into account its share of the S corporation's income, deductions, or losses in figuring unrelated business taxable income, regardless of the actual source or nature of the income, deductions, and losses. H&r block free tax return For example, the organization's share of the S corporation's interest and dividend income will be taxable, even though interest and dividends are normally excluded from unrelated business taxable income. H&r block free tax return The organization must also take into account its gain or loss on the sale or other disposition of the S corporation stock in figuring unrelated business taxable income. H&r block free tax return Special Rules for Foreign Organizations The unrelated business taxable income of a foreign organization exempt from tax under section 501(a) consists of the organization's: Unrelated business taxable income derived from sources within the United States but not effectively connected with the conduct of a trade or business within the United States, and Unrelated business taxable income effectively connected with the conduct of a trade or business within the United States, whether or not this income is derived from sources within the United States. H&r block free tax return To determine whether income realized by a foreign organization is derived from sources within the United States or is effectively connected with the conduct of a trade or business within the United States, see sections 861 through 865 and the related regulations. H&r block free tax return Special Rules for Social Clubs, VEBAs, SUBs, and GLSOs The following discussion applies to: Social clubs described in section 501(c)(7), Voluntary employees' beneficiary associations (VEBAs) described in section 501(c)(9), Supplemental unemployment compensation benefit trusts (SUBs) described in section 501(c)(17), and Group legal services organizations (GLSOs) described in section 501(c)(20). H&r block free tax return These organizations must figure unrelated business taxable income under special rules. H&r block free tax return Unlike other exempt organizations, they cannot exclude their investment income (dividends, interest, rents, etc. H&r block free tax return ). H&r block free tax return (See Exclusions under Income, earlier. H&r block free tax return ) Therefore, they are generally subject to unrelated business income tax on this income. H&r block free tax return The unrelated business taxable income of these organizations includes all gross income, less deductions directly connected with the production of that income, except that gross income for this purpose does not include exempt function income. H&r block free tax return The dividends received by a corporation are not allowed in computing unrelated business taxable income because it is not an expense incurred in the production of income. H&r block free tax return Losses from nonexempt activities. H&r block free tax return   Losses from nonexempt activities of these organizations cannot be used to offset investment income unless the activities were undertaken with the intent to make a profit. H&r block free tax return Example. H&r block free tax return A private golf and country club that is a qualified tax-exempt social club has nonexempt function income from interest and from the sale of food and beverages to nonmembers. H&r block free tax return The club sells food and beverages as a service to members and their guests rather than for the purpose of making a profit. H&r block free tax return Therefore, any loss resulting from sales to nonmembers cannot be used to offset the club's interest income. H&r block free tax return Modifications. H&r block free tax return   The unrelated business taxable income is modified by any NOL or charitable contributions deduction and by the specific deduction (described earlier under Deductions). H&r block free tax return Exempt function income. H&r block free tax return   This is gross income from dues, fees, charges or similar items paid by members for goods, facilities, or services to the members or their dependents or guests, to further the organization's exempt purposes. H&r block free tax return Exempt function income also includes income set aside for qualified purposes. H&r block free tax return Income that is set aside. H&r block free tax return   This is income set aside to be used for religious, charitable, scientific, literary, or educational purposes or for the prevention of cruelty to children or animals. H&r block free tax return In addition, for a VEBA, SUB, or GLSO, it is income set aside to provide for the payment of life, sick, accident, or other benefits. H&r block free tax return   However, any amounts set aside by a VEBA or SUB that exceed the organization's qualified asset account limit (determined under section 419A) are unrelated business income. H&r block free tax return Special rules apply to the treatment of existing reserves for post-retirement medical or life insurance benefits. H&r block free tax return These rules are explained in section 512(a)(3)(E)(ii). H&r block free tax return   Income derived from an unrelated trade or business may not be set aside and therefore cannot be exempt function income. H&r block free tax return In addition, any income set aside and later spent for other purposes must be included in unrelated business taxable income. H&r block free tax return   Set-aside income is generally excluded from gross income only if it is set aside in the tax year in which it is otherwise includible in gross income. H&r block free tax return However, income set aside on or before the date for filing Form 990-T, including extensions of time, may, at the election of the organization, be treated as having been set aside in the tax year for which the return was filed. H&r block free tax return The income set aside must have been includible in gross income for that earlier year. H&r block free tax return Nonrecognition of gain. H&r block free tax return   If the organization sells property used directly in performing an exempt function and purchases other property used directly in performing an exempt function, any gain on the sale is recognized only to the extent that the sales price of the old property exceeds the cost of the new property. H&r block free tax return The purchase of the new property must be made within 1 year before the date of sale of the old property or within 3 years after the date of sale. H&r block free tax return   This rule also applies to gain from an involuntary conversion of the property resulting from its destruction in whole or in part, theft, seizure, requisition, or condemnation. H&r block free tax return Special Rules for Veterans' Organizations Unrelated business taxable income of a veterans' organization that is exempt under section 501(c)(19) does not include the net income from insurance business that is properly set aside. H&r block free tax return The organization may set aside income from payments received for life, sick, accident, or health insurance for the organization's members or their dependents for the payment of insurance benefits or reasonable costs of insurance administration, or for use exclusively for religious, charitable, scientific, literary, or educational purposes, or the prevention of cruelty to children or animals. H&r block free tax return For details, see section 512(a)(4) and the regulations under that section. H&r block free tax return Income From Controlled Organizations The exclusions for interest, annuities, royalties, and rents, explained earlier in this chapter under Income, may not apply to a payment of these items received by a controlling organization from its controlled organization. H&r block free tax return The payment is included in the controlling organization's unrelated business taxable income to the extent it reduced the net unrelated income (or increased the net unrelated loss) of the controlled organization. H&r block free tax return All deductions of the controlling organization directly connected with the amount included in its unrelated business taxable income are allowed. H&r block free tax return Excess qualifying specified payments. H&r block free tax return   Excess qualifying specified payments received or accrued from a controlled entity are included in a controlling exempt organization's unrelated business taxable income only on the amount that exceeds that which would have been paid or accrued if the payments had been determined under section 482. H&r block free tax return Qualifying specified payments means any payments of interest, annuities, royalties, or rents received or accrued from the controlled organization pursuant to a binding written contract in effect on August 17, 2006, or to a contract which is a renewal, under substantially similar terms of a binding written contract in effect on August 17, 2006, and the payments are received or accrued before January 1, 2012. H&r block free tax return   If a controlled participant is not required to file a U. H&r block free tax return S. H&r block free tax return income tax return, the participant must ensure that the copy or copies of the Regulations section 1. H&r block free tax return 482-7 Cost Sharing Arrangement Statement and any updates are attached to Schedule M of any Form 5471, Information Return of U. H&r block free tax return S. H&r block free tax return Persons With Respect To Certain Foreign Corporations, any Form 5472, Information Return of a 25% Foreign-Owned U. H&r block free tax return S. H&r block free tax return Corporation or a Foreign Corporation Engaged in a U. H&r block free tax return S. H&r block free tax return Trade or Business, or any Form 8865, Return of U. H&r block free tax return S. H&r block free tax return Persons With Respect to Certain Foreign Partnerships, filed for that participant. H&r block free tax return Addition to tax for valuation misstatements. H&r block free tax return   Under section 512(b)(13)(E)(ii), the tax imposed on a controlling organization will be increased by 20 percent of the excess qualifying specified payments that are determined with or without any amendments or supplements, whichever is larger. H&r block free tax return See section 512(b)(13)(E)(ii) for more information. H&r block free tax return Net unrelated income. H&r block free tax return   This is: For an exempt organization, its unrelated business taxable income, or For a nonexempt organization, the part of its taxable income that would be unrelated business taxable income if it were exempt and had the same exempt purposes as the controlling organization. H&r block free tax return Net unrelated loss. H&r block free tax return   This is: For an exempt organization, its NOL, or For a nonexempt organization, the part of its NOL that would be its NOL if it were exempt and had the same exempt purposes as the controlling organization. H&r block free tax return Control. H&r block free tax return   An organization is controlled if: For a corporation, the controlling organization owns (by vote or value) more than 50% of the stock, For a partnership, the controlling organization owns more than 50% of the profits or capital interests, or For any other organization, the controlling organization owns more than 50% of the beneficial interest. H&r block free tax return For this purpose, constructive ownership of stock (determined under section 318) or other interests is taken into account. H&r block free tax return   As a result, an exempt parent organization is treated as controlling any subsidiary in which it holds more than 50% of the voting power or value, whether directly (as in the case of a first-tier subsidiary) or indirectly (as in the case of a second-tier subsidiary). H&r block free tax return Income from property financed with qualified 501(c)(3) bonds. H&r block free tax return If any part of a 501(c)(3) organization's property financed with qualified 501(c)(3) bonds is used in a trade or business of any person other than a section 501(c)(3) organization or a governmental unit, and such use is not consistent with the requirements for qualified 501(c)(3) bonds under section 145, the section 501(c)(3) organization is considered to have received unrelated business income in the amount of the greater of the actual rental income or the fair rental value of the property for the period it is used. H&r block free tax return No deduction is allowed for interest on the private activity bond. H&r block free tax return See sections 150(b)(3) and (c) for more information. H&r block free tax return Disposition of property received from taxable subsidiary and used in unrelated business. H&r block free tax return A taxable 80%-owned subsidiary corporation of one or more tax-exempt entities is generally subject to tax on a distribution in liquidation of its assets to its exempt parent (or parents). H&r block free tax return The assets are treated as if sold at fair market value. H&r block free tax return Tax-exempt entities include organizations described in sections 501(a), 529, and 115, charitable remainder trusts, U. H&r block free tax return S. H&r block free tax return and foreign governments, Indian tribal governments, international organizations, and similar non-taxable organizations. H&r block free tax return A taxable corporation that transfers substantially all of its assets to a tax-exempt entity in a transaction that otherwise qualifies for nonrecognition treatment must recognize gain on the transaction as if it sold the assets at fair market value. H&r block free tax return However, such a transfer is not taxable if it qualifies as a like-kind exchange under section 1031 or an involuntary conversion under section 1033. H&r block free tax return In such a case the built-in appreciation is preserved in the replacement property received in the transaction. H&r block free tax return A corporation that changes status from taxable to tax-exempt is treated generally as if it transferred all of its assets to a tax-exempt entity immediately before the change in status (thus subjecting it to the tax on a deemed sale for fair market value). H&r block free tax return This rule does not apply where the taxable corporation becomes exempt within 3 years of formation, or had previously been exempt and within several years (generally a period of 3 years) regains exemption, unless the principal purpose of the transactions is to avoid the tax on the change in status. H&r block free tax return In the transactions described above, the taxable event is deferred for property that the tax-exempt entity immediately uses in an unrelated business. H&r block free tax return If the parent later disposes of the property, then any gain (not in excess of the amount not recognized) is included in the parent's unrelated business taxable income. H&r block free tax return If there is partial use of the assets in unrelated business, then there is partial recognition of gain or loss. H&r block free tax return Property is treated as disposed if the tax-exempt entity no longer uses it in an unrelated business. H&r block free tax return Losses on the transfer of assets to a tax-exempt entity are disallowed if part of a plan with a principal purpose of recognizing losses. H&r block free tax return Income From Debt-Financed Property Investment income that would otherwise be excluded from an exempt organization's unrelated business taxable income (see Exclusions under Income earlier) must be included to the extent it is derived from debt-financed property. H&r block free tax return The amount of income included is proportionate to the debt on the property. H&r block free tax return Debt-Financed Property In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the tax year (or during the 12-month period before the date of the property's disposal, if it was disposed of during the tax year). H&r block free tax return It includes rental real estate, tangible personal property, and corporate stock. H&r block free tax return Acquisition Indebtedness For any debt-financed property, acquisition indebtedness is the unpaid amount of debt incurred by an organization: When acquiring or improving the property, Before acquiring or improving the property if the debt would not have been incurred except for the acquisition or improvement, and After acquiring or improving the property if: The debt would not have been incurred except for the acquisition or improvement, and Incurring the debt was reasonably foreseeable when the property was acquired or improved. H&r block free tax return The facts and circumstances of each situation determine whether incurring a debt was reasonably foreseeable. H&r block free tax return That an organization may not have foreseen the need to incur a debt before acquiring or improving the property does not necessarily mean that incurring the debt later was not reasonably foreseeable. H&r block free tax return Example 1. H&r block free tax return Y, an exempt scientific organization, mortgages its laboratory to replace working capital used in remodeling an office building that Y rents to an insurance company for nonexempt purposes. H&r block free tax return The debt is acquisition indebtedness since the debt, though incurred after the improvement of the office building, would not have been incurred without the improvement, and the debt was reasonably foreseeable when, to make the improvement, Y reduced its working capital below the amount necessary to continue current operations. H&r block free tax return Example 2. H&r block free tax return X, an exempt organization, forms a partnership with A and B. H&r block free tax return The partnership agreement provides that all three partners will share equally in the profits of the partnership, each will invest $3 million, and X will be a limited partner. H&r block free tax return X invests $1 million of its own funds in the partnership and $2 million of borrowed funds. H&r block free tax return The partnership buys as its sole asset an office building that it leases to the public for nonexempt purposes. H&r block free tax return The office building costs the partnership $24 million, of which $15 million is borrowed from Y bank. H&r block free tax return The loan is secured by a mortgage on the entire office building. H&r block free tax return By agreement with Y bank, X is not personally liable for payment of the mortgage. H&r block free tax return X has acquisition indebtedness of $7 million. H&r block free tax return This amount is the $2 million debt X incurred in acquiring the partnership interest, plus the $5 million that is X's allocable part of the partnership's debt incurred to buy the office building (one-third of $15 million). H&r block free tax return Example 3. H&r block free tax return A labor union advanced funds, from existing resources and without any borrowing, to its tax-exempt subsidiary title-holding company. H&r block free tax return The subsidiary used the funds to pay a debt owed to a third party that was previously incurred in acquiring two income-producing office buildings. H&r block free tax return Neither the union nor the subsidiary has incurred any further debt in acquiring or improving the property. H&r block free tax return The union has no outstanding debt on the property. H&r block free tax return The subsidiary's debt to the union is represented by a demand note on which the subsidiary makes payments whenever it has the available cash. H&r block free tax return The books of the union and the subsidiary list the outstanding debt as interorganizational indebtedness. H&r block free tax return Although the subsidiary's books show a debt to the union, it is not the type subject to the debt-financed property rules. H&r block free tax return In this situation, the very nature of the title-holding company and the parent-subsidiary relationship shows this debt to be merely a matter of accounting between the two organizations. H&r block free tax return Accordingly, the debt is not acquisition indebtedness. H&r block free tax return Change in use of property. H&r block free tax return   If an organization converts property that is not debt-financed property to a use that results in its treatment as debt-financed property, the outstanding principal debt on the property is thereafter treated as acquisition indebtedness. H&r block free tax return Example. H&r block free tax return Four years ago a university borrowed funds to acquire an apartment building as housing for married students. H&r block free tax return Last year, the university rented the apartment building to the public for nonexempt purposes. H&r block free tax return The outstanding principal debt becomes acquisition indebtedness as of the time the building was first rented to the public. H&r block free tax return Continued debt. H&r block free tax return   If an organization sells property and, without paying off debt that would be acquisition indebtedness if the property were debt-financed property, buys property that is otherwise debt-financed property, the unpaid debt is acquisition indebtedness for the new property. H&r block free tax return This is true even if the original property was not debt-financed property. H&r block free tax return Example. H&r block free tax return To house its administration offices, an exempt organization bought a building using $600,000 of its own funds and $400,000 of borrowed funds secured by a pledge of its securities. H&r block free tax return The office building was not debt-financed property. H&r block free tax return The organization later sold the building for $1 million without repaying the $400,000 loan. H&r block free tax return It used the sale proceeds to buy an apartment building it rents to the general public. H&r block free tax return The unpaid debt of $400,000 is acquisition indebtedness with respect to the apartment building. H&r block free tax return Property acquired subject to mortgage or lien. H&r block free tax return   If property (other than certain gifts, bequests, and devises) is acquired subject to a mortgage, the outstanding principal debt secured by that mortgage is treated as acquisition indebtedness even if the organization did not assume or agree to pay the debt. H&r block free tax return Example. H&r block free tax return An exempt organization paid $50,000 for real property valued at $150,000 and subject to a $100,000 mortgage. H&r block free tax return The $100,000 of outstanding principal debt is acquisition indebtedness, as though the organization had borrowed $100,000 to buy the property. H&r block free tax return Liens similar to a mortgage. H&r block free tax return   In determining acquisition indebtedness, a lien similar to a mortgage is treated as a mortgage. H&r block free tax return A lien is similar to a mortgage if title to property is encumbered by the lien for a creditor's benefit. H&r block free tax return However, when state law provides that a lien for taxes or assessments attaches to property before the taxes or assessments become due and payable, the lien is not treated as a mortgage until after the taxes or assessments have become due and payable and the organization has had an opportunity to pay the lien in accordance with state law. H&r block free tax return Liens similar to mortgages include (but are not limited to): Deeds of trust, Conditional sales contracts, Chattel mortgages, Security interests under the Uniform Commercial Code, Pledges, Agreements to hold title in escrow, and Liens for taxes or assessments (other than those discussed earlier in this paragraph). H&r block free tax return Exception for property acquired by gift, bequest, or devise. H&r block free tax return   If property subject to a mortgage is acquired by gift, bequest, or devise, the outstanding principal debt secured by the mortgage is not treated as acquisition indebtedness during the 10-year period following the date the organization receives the property. H&r block free tax return However, this applies to a gift of property only if:    The mortgage was placed on the property more than 5 years before the date the organization received it, and The donor held the property for more than 5 years before the date the organization received it. H&r block free tax return   This exception does not apply if an organization assumes and agrees to pay all or part of the debt secured by the mortgage or makes any payment for the equity in the property owned by the donor or decedent (other than a payment under an annuity obligation excluded from the definition of acquisition indebtedness, discussed under Debt That Is Not Acquisition Indebtedness, later). H&r block free tax return   Whether an organization has assumed and agreed to pay all or part of a debt in order to acquire the property is determined by the facts and circumstances of each situation. H&r block free tax return Modifying existing debt. H&r block free tax return   Extending, renewing, or refinancing an existing debt is considered a continuation of that debt to the extent its outstanding principal does not increase. H&r block free tax return When the principal of the modified debt is more than the outstanding principal of the old debt, the excess is treated as a separate debt. H&r block free tax return Extension or renewal. H&r block free tax return   In general, any modification or substitution of the terms of a debt by an organization is considered an extension or renewal of the original debt, rather than the start of a new one, to the extent that the outstanding principal of the debt does not increase. H&r block free tax return   The following are examples of acts resulting in the extension or renewal of a debt: Substituting liens to secure the debt, Substituting obligees whether or not with the organization's consent, Renewing, extending, or accelerating the payment terms of the debt, and Adding, deleting, or substituting sureties or other primary or secondary obligors. H&r block free tax return Debt increase. H&r block free tax return   If the outstanding principal of a modified debt is more than that of the unmodified debt, and only part of the refinanced debt is acquisition indebtedness, the payments on the refinanced debt must be allocated between the old debt and the excess. H&r block free tax return Example. H&r block free tax return An organization has an outstanding principal debt of $500,000 that is treated as acquisition indebtedness. H&r block free tax return The organization borrows another $100,000, which is not acquisition indebtedness, from the same lender, resulting in a $600,000 note for the total obligation. H&r block free tax return A payment of $60,000 on the total obligation would reduce the acquisition indebtedness by $50,000 ($60,000 x $500,000/$600,000) and the excess debt by $10,000. H&r block free tax return Debt That Is Not Acquisition Indebtedness Certain debt and obligations are not acquisition indebtedness. H&r block free tax return These include the following. H&r block free tax return Debts incurred in performing an exempt purpose. H&r block free tax return Annuity obligations. H&r block free tax return Securities loans. H&r block free tax return Real property debts of qualified organizations. H&r block free tax return Certain Federal financing. H&r block free tax return Debt incurred in performing exempt purpose. H&r block free tax return   A debt incurred in performing an exempt purpose is not acquisition indebtedness. H&r block free tax return For example, acquisition indebtedness does not include the debt an exempt credit union incurs in accepting deposits from its members or the debt an exempt organization incurs in accepting payments from its members to provide them with insurance, retirement, or other benefits. H&r block free tax return Annuity obligation. H&r block free tax return   The organization's obligation to pay an annuity is not acquisition indebtedness if the annuity meets all the following requirements. H&r block free tax return It must be the sole consideration (other than a mortgage on property acquired by gift, bequest, or devise that meets the exception discussed under Property acquired subject to mortgage or lien, earlier in this chapter) issued in exchange for the property received. H&r block free tax return Its present value, at the time of exchange, must be less than 90% of the value of the prior owner's equity in the property received. H&r block free tax return It must be payable over the lives of either one or two individuals living when issued. H&r block free tax return It must be payable under a contract that: Does not guarantee a minimum nor specify a maximum number of payments, and Does not provide for any adjustment of the amount of the annuity payments based on the income received from the transferred property or any other property. H&r block free tax return Example. H&r block free tax return X, an exempt organization, receives property valued at $100,000 from donor A, a male age 60. H&r block free tax return In return X promises to pay A $6,000 a year for the rest of A's life, with neither a minimum nor maximum number of payments specified. H&r block free tax return The amounts paid under the annuity are not dependent on the income derived from the property transferred to X. H&r block free tax return The present value of this annuity is $81,156, determined from IRS valuation tables. H&r block free tax return Since the value of the annuity is less than 90 percent of A's $100,000 equity in the property transferred and the annuity meets all the other requirements just discussed, the obligation to make annuity payments is not acquisition indebtedness. H&r block free tax return Securities loans. H&r block free tax return   Acquisition indebtedness does not include an obligation of the exempt organization to return collateral security provided by the borrower of the exempt organization's securities under a securities loan agreement (discussed under Exclusions earlier in this chapter). H&r block free tax return This transaction is not treated as the borrowing by the exempt organization of the collateral furnished by the borrower (usually a broker) of the securities. H&r block free tax return   However, if the exempt organization incurred debt to buy the loaned securities, any income from the securities (including income from