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year and choose a method of accounting just as if it were a taxpayer. Other aspects of the entity concept are briefly discussed below. ElectionsElections come under the entity approach. IRC section 703(b) lists three elections that will be made by each partner separately - all other elections must be made by the partnership. The three elections that partners are to make individually are: 1. Elections pertaining to exclusion of cancellation of debt income under IRC section 108; 2. The IRC section 617 election to expense mining exploration expenditures; 3. The election under IRC section 901 to deduct foreign taxes. One of the most common partnership elections is the IRC section 754 election which permits the partnership to adjust the basis of its assets. Profit Motive/Trade or BusinessProfit motive is determined at the partnership level, and not at the level of the individual partners. This means that questions concerning whether expenses are incurred in carrying on a trade or business within the meaning of IRC section 162(a) are addressed at the partnership level. Character of Separately Stated ItemsThe entity theory governs the characterization of partnership income, gain, loss, deductions, and credits. How the partner wishes to characterize these items has no relevance. Although a partnership does not pay tax, the partnership computes taxable income and determines the character of the income, gain, loss, deductions and credits. Items that could have a special significance to different taxpayers are separately stated under IRC section 702. Treas. Reg. section 1.702-1(b) states that “the character in the hands of a partner of any item of income, gain, loss, deduction, or credit described in IRC section 702(a)(1) through (8) shall be determined as if such item were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership.” For example, capital gains and losses and charitable contributions are separately stated, since they could affect each partner differently, depending on the partner’s individual tax profile. Issue IdentificationDetermine if there was IRC section 704(c) property contributed to the partnership. The book capital accounts and the tax capital accounts should reflect a different value for the contributed property. The examiner may look to the outside basis computation, if it is more readily available, for the adjusted basis in the asset. The examiner should verify the adjusted basis and the FMV of contributed property.
Review subsequent transactions to determine if the pre-contribution gain or loss should be recognized. It may be missing from a subsequent balance sheet or the Schedule M-2 may notate a distribution of property to a partner. This could be a distribution of the IRC section 704(c) property to another partner or the distribution of other property to the contributing partner of the original IRC section 704(c) property. There may be a disposition, a disguised sale, or a “mixing bowl” type of transaction that will all trigger gain recognition. Also, if the property was depreciable property, the separately stated depreciation deduction will not be present in subsequent Schedules K-1.