Won’t You Be My Partner?

Partnerships are nothing new to accounting, but venture capital is. Often private equity arrangements create complicated partnership structures, and with those come complicated compliance issues.

Partnerships and LLCs taxed as partnerships are proliferating in the business environment. Maybe you read the above headline as an invitation to dance – which it is in a way. Or maybe you see an homage to Mister Rogers’ Neighborhood, though this would be purely ironic. The neighborhood, it seems, is getting a little crowded with wonderfully flexible but complex business entities. This article intends to provide an update on current developments in the taxation of partnerships.

Background

A “partnership” and a “partner” are defined for federal tax purposes as “a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term ‘partner’ includes a member in such a syndicate, group, pool, joint venture, or organization.”¹ That definition is about as broad as you can get. Here’s the simple definition: if you are not an individual, a trust or estate, or a corporation, and there is more than one owner, you are generally a partnership.

IRC Section 701 establishes the principal that a partnership is generally not taxed under Title 26 Chapter 1 of the U.S. Code, but the individual partners are taxed on the economic activity of the partnership – also known as a pass-through entity.

Economic activity must be reported to each partner in eight categories pursuant to IRC Section 702(a). That statute establishes the reporting of nonseparately stated business income or loss and separately stated items. Section 702(b) establishes the premise that the character of items in the hands of the partnership is passed through to the partners. All of the separately stated and nonseparately stated elements are reported on Schedule K, and each partner’s items are reported on Schedule K-1. Allocations under Section 704 of those elements of partnership items are where the fun begins.

Section 703 establishes that partnerships will follow the rules of tax applicable to individuals, acknowledging the need for nonseparately stated business income and separately stated items. The statute disallows a number of deductions applicable to individuals, such as personal exemptions, charitable deductions, and taxes.

Venture Capital and Private Equity

The proliferation of complicated and tiered structures used in venture capital and private equity partnerships means there is a lot of work to do in the partnership space, and that work is complex. As venture capital and private equity investments in CPA firms roll up and consolidate the industry, CPAs themselves may have to perform complicated partnership return preparations on their own behalf. Three topics to consider are partner allocations, loss limitation regimes, and the AICPA Professional Ethics Executive Committee (PEEC) work on independence.

Allocations – Section 704 is where partnership taxation gets interesting. Section 704(a) establishes the principle that a partnership agreement determines the allocation of the nonseparately stated business income and separately stated items. The IRS must respect those allocations, unless those allocations lack substantial economic effect. Section 704(b) establishes that in absence of a partnership agreement the partner’s distributive share of nonseparately stated business income and separately stated items is determined by the partner’s interest in the partnership.

But what exactly does this mean? We tend to focus on the capital ownership or profits percentage. However, a partner’s interest in a partnership – as defined in Treas. Reg. 1.704-1(b)(3)(i) – is more complicated. The determination of the interest in a partnership includes the capital interest in liquidation but also includes relative contributions to the partnership, profits interests, loss interests, interests in cash flows or distributions, guaranteed payments, and other special allocations.

In more complicated partnership structures – venture-backed or private-equity structures – certain fund managers may receive profit-only interest in exchange for their services in organizing and marketing partnership interests. While partnership interest received for services rendered is generally taxable as compensation, under Rev. Proc. 93-17 partners who receive a profits-interest-only recognize no compensation because the value of that interest is indeterminate. That beneficial “carried interest” regime is a topic for another article.

Tiered structures may have complicated “waterfall” provisions or member-operating agreements that include return of capital, preferred or minimum returns, catch-up provisions, general partners’ carried interests, or clawback provisions. These wrinkles may affect a partner’s interest and the allocation of nonseparately stated items and separately stated items in partnership returns.

The takeaway for CPAs is that you will need to invest some time into understanding partnership allocations and developing/updating your Excel templates to accommodate more complicated allocations.

Loss Limitation Regimes and Allocation of Liabilities – Allocations can’t be addressed without discussing the loss limitation regimes applicable to partners. There are four applicable loss limitation regimes to discuss here: adjusted basis under Section 704(d)(1) and (2), at-risk under Section 465, passive activity under Section 469, and excess business under Section 461(l).

Adjusted Basis Limitation: Losses are limited first by the partner’s adjusted basis in their partnership interest. This is addressed in Sections 705(a), 722, and 742.

“The adjusted basis of a partner’s interest in a partnership shall, except as provided in subsection (b), be the basis of such interest determined under Section 722 (relating to contributions to a partnership) or Section 742 (relating to transfers of partnership interests).” IRC Section 722 states: “The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under Section 721(b) to the contributing partner at such time.”

See Sections 705(a), 722, 733(1) and (2), and 752(a) and (b) for more details.

At-Risk Limitation: The at-risk limitation logic of Section 465 follows the adjusted-basis logic with these notable differences:

• At-risk amounts exclude nonrecourse debt.
• Certain debts owed by the partnership to a person with a partnership interest.
• Any amounts subject to contractual or other arrangements that limit a partner’s risk.

Inherent in the adjusted-basis and at-risk loss limitations are the allocation of partnership liabilities and the existence of deficit restoration, targeted distribution rights, or qualified income offset provisions in the partnership or member operating agreement.

Passive Activity Limitation: Section 469(a)(1) provides the general disallowance of passive activity losses (PAL) and credits. Passive activities are any trade or business activity in which a partner does not materially participate pursuant to Section 469(c)(1). Section 469(c)(2) identifies all rental activities as passive activities, except for taxpayers engaged in real property businesses (real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage). The exception applies to taxpayers who spend more than half of their service time in real property businesses in which the taxpayer materially participates and spends more than 750 hours in the tax year in those real property businesses.

“Material participation” is technically explained in Treas. Reg. 1.469-5T (a)(1) through (a)(7), but those definitions are factually dependent, and the determination may cross multiple tax years of activity. Any time a tax determination rests on “all facts and circumstances,” contemporaneous documentation is requisite. Obtaining time records from partners can be challenging. So, the use of check-sheets and PAL time-tracking templates can help reduce the time to gather the information.

Passive activity loss limitations are computed in aggregate at the partner level, as required by Section 469(d). The passive activity loss for any tax year is equal to the losses generated by passive activities plus carryforward PALs in excess of income generated by passive activities. For individuals, those calculations are reported on Form 8582, Passive Activity Loss Limitations. Corporations report on Form 8810, Corporate Passive Activity Loss and Credit Limitations.

Excess Business Loss Limitation: The One Big Beautiful Bill Act (OBBBA) of 2025 modified the excess business loss regime under Section 461(l). (It had been set to expire after 2028.) The OBBBA made the loss limitation regime permanent. Section 461(l) limits pass-through business losses, and any loss suspended under that rule becomes a Section 172 net operating loss (NOL) subject only to NOL rules for usage and limitations.

An “excess business loss” is the amount by which the aggregate deductions attributable to all of a taxpayer’s trades or businesses exceed the sum of:

• The aggregate gross income or gain attributable to those trades or businesses, plus
• A threshold amount (adjusted annually for inflation).

The threshold amounts for 2025 are $313,000 for single filers and $626,000 for joint filers.

Independence of the CPA Firm – AICPA’s PEEC is attempting to determine independence within complicated partnership structures that support the introduction of venture capital and private equity investments in CPA firms. A revised exposure draft is available on the AICPA-CIMA website.² The due date for comments is April 30, 2026.

The PEEC is working to understand if, how, and when independence is impaired for a CPA firm when venture capital or private equity investments are made and “alternative practice structures” are created. The exposure draft identifies and charts a variety of ownership structures, including publicly traded, networks of firms, investment funds, and investment managers. The PEEC defines an alternative practice structure as “one in which a firm that provides attest services (attest firm) is closely aligned with another public or private entity, partly or wholly owned by an investor or investors, that performs professional services other than attest services (nonattest entity).”

Many alternative practice structures involve partnerships or entities taxed as partnerships. They often have complicated partnership or member operating agreements that require complex allocations of nonseparately stated business income and separately stated items, allocations of liabilities, and concomitant outside partner basis and at-risk calculations. Please consider reviewing the document and submitting comments by the April 30, 2026, deadline.

Self-Employment Tax

Soroban Capital Partners LP, Soroban Capital Partners GP LLC, Tax Matters Partner v. Commissioner of Internal Revenue was filed May 28, 2025.³ The case is important because it establishes a new functional test for determining when limited partners are subject to self-employment tax under Section 1402(a). Section 1402(a)(13) excludes “income or loss of a limited partner, as such” when calculating net earnings from self-employment. The Tax Court previously held that a functional analysis was necessary to determine the extent to which the limited partner exception applies.⁴

The 2025 case was decided by affirming the use of the functional test, and the Tax Court stated the partners were limited partners in name only. Those partners were essential in generating the business’s income, oversaw day-to-day management, worked full-time in the business, and therefore were not limited partners within the meaning of the exclusion from self-employment tax. For any partner earning less than the Social Security component (12.4% of the 15.3% self-employment tax), the functional analysis could result in a significant tax liability. For those limited partners in excess of the cap, only the Medicare portion of the self-employment tax is in play (2.9% of the 15.3%). There may be some economic offset in calculating the net investment income tax (3.8%).

A decision in the Sirius Solutions case was issued Jan. 16, 2026. That decision reshapes the limited partner exception to the self-employment tax.⁵ The Fifth Circuit Court of Appeals vacated a Tax Court ruling that applied the functional test. The Fifth Circuit basically said, “What don’t you understand about ‘limited partner’?” If the partner has limited liability, the partner is a limited partner for the purposes of the self-employment tax exception.

So, where do these two cases leave the actively engaged limited partner? There is likely substantial authority to exclude those partner allocations (not guaranteed payments if any) of nonseparately stated business income and separately stated items from reported self-employment income. Therefore, any time that was spent revisiting limited partners’ activities in 2025 may have been wasted.

Basis-Shifting Transaction Guidance

In April 2025, the IRS retracted its partnership basis-shifting guidance with IRS Notice 2025-23. That retraction was based on Executive Order 14219, Ensuring Lawful Governance and Implementing the President’s “Department of Government Efficiency” Deregulatory Initiative. The previous guidance, issued in June 2024, had identified certain basis-shifting transactions as transactions of interest, and had required complex and challenging disclosures on what many argued were ordinary course-of-business transactions.

Form 7217

IRS Form 7217 is effective for tax years beginning Jan. 1, 2024. Partners who receive noncash property distributions subject to Section 732 from a partnership must file Form 7217 with their return. A separate form is required for each date on which a partner received a distribution of property.

The IRS requires Form 7217 to accurately report and document the partner’s adjusted basis in the property received. Form 7217 is not required if the distribution is for cash or marketable securities treated as cash, for services rendered by the partner to the partnership, or for disguised sales under Section 707.

The IRS hopes to enhance transparency in reporting property distributions to standardize basis tracking and disclosure at the partner level, support enforcement (particularly with basis shifting), monitor basis adjustments, reduce abuse and errors in reporting basis of property distributed, and improve auditability.

Data elements include the partnership’s basis before distribution, fair market value of the property distributed, partner’s basis after basis allocations, and any special basis adjustments arising from Sections 734(b), 743(b), 732(d), and 732(f). You should include Form 7217 compliance in your return review checklist for Form 1065.

Conclusion

Whew! That was a lot of technical changes for partnerships. Hopefully, this article refreshed your memory on the basics of partnership information reporting. Also, I hope you heed the heads-up call to watch the impact of the proliferation of complex venture capital and private equity ownership structures, specifically allocations of partnership items, loss limitations and, within CPA firms, the effect of those venture capital and private equity investments on CPA firm independence.

If this all sounds too familiar to you and you’ve worn a bald spot on your head as you’ve pondered all these permutations, all I can say is “Welcome to the partnerhood!” 

¹ Internal Revenue Code Section 7701(a)(2).

² www.aicpa-cima.com/resources/download/ethics-APS-ED

³ Soroban Cap. v. Commissioner, T.C. Memo. 2025-52, No. 16217-22, 2025 BL 18241.

⁴ Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023).

⁵ Sirius Solutions LLLP; Sirius Solutions GP LLC; Tax Matters Partner v. Commissioners, No. 24*60240, Jan. 16, 2026, Appeal from the United States Tax Court Agency Nos. 11587-20, 30118-21.

Edward R. Jenkins Jr., CPA, CGMA, is professor of practice in accounting at Penn State in University Park, managing member of Jenkins & Co. LLC in Lemont, and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at erj2@psu.edu.