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contributions (10,000)

      J and D are each 50% partners. The partnership will report ordinary business income of $207,000 ($300,000 – 50,000 – 25,000 – 18,000) on page 1 of Form 1065. This amount will be carried to Schedule K (line 1), which will also report, on separate lines, the partnership's long-term capital gains of $15,000, interest income of $7,000 and charitable contributions of ($10,000). Each of the partners will receive a Schedule K-1 (see the appendix to this course for a sample) showing his or her $103,500 share of partnership ordinary income, $7,500 share of partnership long-term capital gain, $3,500 share of partnership interest income and ($5,000) share of partnership charitable contributions. This result is illustrated in the following table:

Description	Form 1065, p.1	Schedule K	Schedule K-1, J	Schedule K-1, D
Net ordinary business income	$207,000	$207,000	$103,500	$103,500
Separately stated items:
Long-term capital gains		15,000	7,500	7,500
Interest income		7,000	3,500	3,500
Charitable contributions		10,000	5,000	5,000
Analysis of net income (Loss)			$219,000

       Example 1-15

Consider the facts of example 1-14. Assume partner J incurred net capital losses outside the partnership of ($5,500) and had net investment interest expense (in excess of investment income) of ($2,000). D, the other partner, had no capital gains or losses outside the partnership, and no investment interest expense. For the current year, J's share of partnership income (and the items thereof) will cause her taxable income to increase by $102,000 ($103,500 ordinary income, plus $7,500 long-term capital gain, plus $3,500 interest income, less ($5,000) charitable contributions, less additional capital loss deduction of ($5,500) and additional investment interest expense deduction of ($2,000)). D's share of partnership items, in contrast, will increase her current year taxable income by $109,500 ($103,500 + $7,500 + $3,500 – $5,000). Having no capital losses or excess investment interest expense outside the partnership, her share of partnership items does not increase her other deductions as it did for J.

      Effect on the partners: Basis

      Partners are taxable on their shares of partnership income whether or not that income is distributed to them. Where some or all of a partner's share of partnership income is not distributed (that is, is retained by the partnership) the excess represents an additional investment by the partner in the partnership. Accordingly, under Section 705(a)(1), a partner's share of items of partnership income, including nontaxable income (for example, municipal bond interest) increases his or her basis in the partnership interest. Basis is then reduced by the portion, if any, of that income which is distributed to the partner during the year.

       Example 1-16

      Elaine and Jerry formed a partnership early last year to purchase rental properties. They each contributed $25,000 to the partnership, which then borrowed $150,000 on a recourse loan, and purchased rental real estate. Each partner's initial basis in the partnership interest was therefore $100,000 ($25,000 contributed plus $75,000 share of debt). In its first year, the partnership reported net income of $30,000, and made distributions to Elaine and Jerry of $8,000 each. Elaine and Jerry will each report $15,000 income on their individual returns (their shares of the partnership's $30,000 income) even though they received only $8,000 in distributions. Their bases in their partnership interests will be $107,000 at year-end ($100,000 initial basis, plus $15,000 share of partnership income, less $8,000 distribution received).

At first glance, it may seem unusual for the partner to be allowed to increase basis in the partnership interest by his or her share of nontaxable income. This basis adjustment, however, is necessary to prevent the tax-exempt income from indirectly becoming taxable when the partner later sells or otherwise disposes of his or her interest in the partnership.The tax-exempt income increases the partnership's net assets, and therefore, presumably, the value of the equity interests in the partnership. An increase in value, without a corresponding increase in basis, would cause more gain to be recognized upon a subsequent sale of the interest.

       Example 1-17

      Tim is a 20% partner in Sparrowhawk Partners. He contributed $40,000 to the newly-formed partnership in exchange for his interest early this year. The partnership invested all its capital in municipal bonds. For the year, Tim's share of the partnership's municipal bond interest income was $2,000. The partnership had no other items of income or loss. Although this income is not taxable, it increases Tim's share of partnership assets to $42,000. If he were not required to increase his tax basis in the partnership interest by his share of the tax- exempt municipal bond interest, a subsequent sale of that interest for its $42,000 value would trigger a $2,000 taxable gain to Tim. (His initial basis in the partnership interest was $40,000.) The basis adjustment preserves the tax-exempt nature of the income allocated to Tim.

      If the partnership reports a loss, rather than a profit, each partner's share of the loss reduces his or her interest in the partnership's remaining partnership assets. Section 705(a)(2) requires that the partner's basis in the partnership interest be reduced by his or her share of each item of partnership loss or expense, including nondeductible losses or expenses. The reason nondeductible expenses reduce the partner's basis in the partnership interest is similar to the reason tax-exempt income increases basis. If a partner's basis was not reduced for nondeductible expenses, the partner would presumably have a greater loss or lower gain on the sale of the partnership, which would be essentially equivalent to making the expenses deductible.

       Example 1-18

      Dennis is a 10% partner in Dame Partners. At the beginning of the year, his basis in Dame was $25,000. For the year, Dennis received a K-1 from Dame Partners reporting that his share of partnership ordinary income or loss was ($12,000), and his share of partnership interest income was $2,500. Dennis' basis in his partnership interest at the end of the year will be $15,500 ($25,000 - $12,000 + $2,500).

In summary, partners include their shares of each item of partnership income, gain, loss, or deduction on their own tax returns each year, whether distributed to them or not. A partner's basis in his or her partnership interest is adjusted upward by his or her share of items of partnership income or gain. It is adjusted downward

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