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6.1 Form 1065, Schedule K & Schedule K-1 Separately Stated Items
EA Part 2 — Businesses: Free Study Guide 2026 Exam
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1 Chapter 1: Exam Cycle & Preparation
1.1 Current Exam Cycle, Blueprint & Study Decisions
2 Chapter 2: Business Entity Choices & Classification
2.1 Business Structures & Liability: Sole Proprietorship, Partnership, LLC, and Corporation 2.2 Entity Classification & Check-the-Box Rules (Form 8832) 2.3 Classification Elections, Default Rules & the 60-Month Limitation 2.4 EINs, Entity Changes & Closing a Business
3 Chapter 3: Sole Proprietorships
3.1 Schedule C Gross Income & Allowable Business Expenses 3.2 Self-Employment Tax (Schedule SE) & Statutory Employees 3.3 Business Use of Home (Simplified vs. Actual Method)
4 Chapter 4: Partnership Formation & Basis
4.1 Formation & Property Contributions under Section 721 4.2 Partner Liabilities under Section 752 (Recourse vs. Nonrecourse) 4.3 Partnership Tax Year, Accounting Periods & Form 1065 Filing 4.4 Family Partnerships, Gifted Interests & Income Allocations
5 Chapter 5: Partnership Basis & Loss Limitations
5.1 Outside Basis Calculations & Ordering Rules 5.2 Basis, At-Risk (§465) & Passive Loss (§469) Limitations 5.3 Excess Business Losses (§461(l)) & Related-Party Transactions (§707) 5.4 Debt Discharge: Partnership vs. S Corporation
6 Chapter 6: Partnership Operations & Distributions
6.1 Form 1065, Schedule K & Schedule K-1 Separately Stated Items 6.2 Guaranteed Payments vs. Distributive Shares 6.3 Nonliquidating & Liquidating Distributions & Section 751 Hot Assets 6.4 Centralized Partnership Audits, Notices & Opting Out
7 Chapter 7: Partnership Dispositions & Basis Adjustments
7.1 Sale or Exchange of a Partnership Interest 7.2 Optional Basis Adjustments (Section 754, 743(b) & 734(b)) 7.3 Partnership Terminations, Mergers & Divisions
8 Chapter 8: C Corporation Formation & Structure
8.1 Corporate Formation & Section 351 Transfer Requirements 8.2 Boot, Section 357 Liabilities in Excess of Basis & Section 1244 Stock 8.3 Capital Structure: Debt vs. Equity & Section 385 Principles 8.4 Controlled Groups & Closely Held Corporations
9 Chapter 9: C Corporation Operations & E&P
9.1 Form 1120 Gross Income, Corporate Deductions & 21% Flat Tax Rate 9.2 Book-Tax Differences (Schedule M-1 vs. Schedule M-3) 9.3 Current vs. Accumulated Earnings & Profits (E&P) 9.4 Accumulated Earnings & Personal Holding Company Taxes 9.5 Corporate Minimum Tax & Foreign Tax Credits
10 Chapter 10: C Corporation Distributions & Liquidations
10.1 Property Distributions, Dividends & Constructive Distributions 10.2 Stock Redemptions (§302) & Corporate Liquidations (§331/§336)
11 Chapter 11: S Corporation Eligibility & Operations
11.1 S Corporation Requirements & Form 2553 Election Rules 11.2 Election Deadlines, Late Election Relief (Rev. Proc. 2013-30) 11.3 Form 1120-S Operations, Reasonable Compensation & 2% Shareholder Fringes
12 Chapter 12: S Corporation Basis, Distributions & Taxes
12.1 Stock & Debt Basis Calculations, Ordering Rules & Form 7203 12.2 S Corp Distributions, Accumulated Adjustments Account (AAA) & E&P Tiers 12.3 Entity-Level Taxes (BIG §1374 & Passive Income §1375) & Termination
13 Chapter 13: Accounting Periods & Methods
13.1 Tax Years: Calendar, Fiscal, and 52-53 Week Years 13.2 Cash vs. Accrual Method & Section 448 Gross Receipts Test 13.3 Changes in Accounting Method (Form 3115) & Section 481(a) Adjustments 13.4 2025 Domestic Research Expensing & Foreign Research
14 Chapter 14: Business Gross Income & Inventory
14.1 Gross Receipts & Inclusions in Business Gross Income 14.2 Cost of Goods Sold (COGS) & Inventory Valuation (Cost, LCM, FIFO, LIFO) 14.3 Section 263A Uniform Capitalization (UNICAP) & Small Business Exemption
15 Chapter 15: General Business Deductions & Limits
15.1 Ordinary & Necessary Business Expenses (§162) & Disallowances 15.2 Business Meals, Gifts & Travel 15.3 Vehicle Expenses, Mileage & Substantiation 15.4 Business Interest Expense Limitation (§163(j)) & Business Taxes
16 Chapter 16: Business Losses & Net Operating Losses
16.1 Net Operating Losses (NOLs) 80% Taxable Income Cap & Carryforward Rules 16.2 Business Casualty, Theft & Disaster Losses 16.3 Business vs. Nonbusiness Bad Debts (Direct Write-Off Method §166)
17 Chapter 17: Section 199A Qualified Business Income Deduction
17.1 Section 199A Overview: 20% Deduction & Qualified Trades or Businesses 17.2 Specified Service Trades or Businesses (SSTBs) & Threshold Phase-Outs 17.3 W-2 Wage & UBIA Limitations Calculation & Aggregation Rules
18 Chapter 18: Depreciation Principles & MACRS
18.1 Depreciable Property, Cost Basis & Capitalization vs. Repair Regulations 18.2 MACRS Property Classes (3, 5, 7, 15, 27.5, 39-Year) & Depreciation Methods 18.3 Depreciation Conventions: Half-Year, Mid-Quarter (40% Rule) & Mid-Month
19 Chapter 19: Section 179 Expensing & Bonus Depreciation
19.1 Section 179 Expensing: $2.5M Limit, $4M Phase-Out & Taxable Income Limitation 19.2 2025 Bifurcated Bonus Depreciation: Pre-Jan 20 (40%) vs. Post-Jan 19 (100% OBBBA) 19.3 Listed Property Rules, >50% Business Use & Section 280F Luxury Auto Limits
20 Chapter 20: Amortization & Intangible Assets
20.1 Section 197 Intangibles & 15-Year Straight-Line Amortization 20.2 Start-Up (§195) & Organizational (§248/§709) Expenditures: $5,000 Rule & 180-Month Amortization 20.3 Depletion: Cost Depletion vs. Percentage Depletion for Natural Resources
21 Chapter 21: Business Property Dispositions & Recapture
21.1 Sale of Business Property & Reporting on Form 4797 21.2 Section 1231 Netting Process & 5-Year Lookback Recapture Rule 21.3 Section 1245 (Full Personal Property Recapture) & Section 1250 / Unrecaptured §1250 Gain
22 Chapter 22: Like-Kind Exchanges & Involuntary Conversions
22.1 Section 1031 Like-Kind Exchanges (Real Property Only, 45-Day/180-Day Deadlines) 22.2 Boot Recognition & Basis Calculation for Replacement Property 22.3 Section 1033 Involuntary Conversions & Replacement Periods
23 Chapter 23: Business Tax Credits
23.1 General Business Credit (Form 3800), Net Income Tax Limit & Carryback/Carryforward 23.2 Key Business Tax Credits: Research Credit (§41), WOTC (§51), Small Employer Health (§45R)
24 Chapter 24: Worker Classification & Information Reporting
24.1 Employee vs. Independent Contractor: Common Law Control & Form SS-8 24.2 Section 530 Relief Requirements & Consequences of Misclassification 24.3 Information Returns: Form 1099-NEC vs. 1099-MISC, Form W-2/W-3 & Backup Withholding
25 Chapter 25: Employment Taxes & Compliance
25.1 Form 941 (Quarterly Payroll Tax Return) & Federal Income Tax / FICA Withholding 25.2 Federal Unemployment Tax (Form 940) & State Unemployment Credit 25.3 Payroll Tax Deposit Schedules (Monthly vs. Semi-Weekly, $100K Rule) & Trust Fund Penalty (§6672)
26 Chapter 26: Fiduciary Income Taxation (Trusts & Estates)
26.1 Principles of Fiduciary Income Taxation & Form 1041 Filing Requirements 26.2 Fiduciary Tax Years, Exemptions & Estimated Payments 26.3 Simple and Complex Trusts, Tiers & Distribution Timing 26.4 DNI Computation & Fiduciary Expense Allocation 26.5 Income Distribution Deduction & Schedule K-1 (Form 1041) Flow-Through 26.6 Foreign Trusts, Grantor Control & Abusive Schemes
27 Chapter 27: Tax-Exempt Organizations & Farm Taxation
27.1 Recognition of Tax Exemption (Form 1023/1024) & §501(c)(3) Standards 27.2 Maintaining Exemption, Political Activity & Excess Benefits 27.3 Form 990 Series Annual Returns & Unrelated Business Taxable Income (UBTI / Form 990-T) 27.4 Unrelated Business Income & Debt-Financed Property 27.5 Farm Income, Schedule F & Conservation Costs 27.6 Farm Income Averaging & Conservation Deductions 27.7 Farm Disaster Elections & Livestock Replacement 27.8 Farm Rentals, Estimated Tax & Farm Depreciation
28 Chapter 28: Business Records, Reporting & ACA
28.1 Financial Statements, Records & Owner Transactions 28.2 Filing Extensions, International Forms & Cash Reporting 28.3 ACA Employer Size, Coverage & Reporting
29 Chapter 29: Employer & Self-Employed Retirement Plans
29.1 Qualified Plans, 401(k) Limits & Nondiscrimination 29.2 SEPs, Self-Employed Contributions & Owner Compensation 29.3 SIMPLE IRAs & Small-Employer Contribution Choices 29.4 Plan Reporting, Loans & Prohibited Transactions
30 Chapter 30: Rental Property & Passive Activities
30.1 Rental Income, Expenses & Conversion Basis 30.2 Rental Losses, Active Participation & Real Estate Professionals 30.3 Vacation Homes, Personal Days & Rental Allocations
6.1 Form 1065, Schedule K & Schedule K-1 Separately Stated Items
Key Takeaways Explain This Topic AI
A partnership is a pass-through entity under IRC §701; it files an informational Form 1065 and pays no federal income tax at the entity level.
Page 1 of Form 1065 calculates ordinary business income or loss, representing gross profit minus allowable trade deductions such as guaranteed payments, non-partner employee wages, rent, and MACRS depreciation.
Under IRC §702(a) and §703(a), any income, gain, loss, deduction, or credit that could alter the tax liability of any individual partner if separately stated must bypass Page 1 and appear on Schedule K and Schedule K-1.
Core separately stated items include net capital gains and losses, Section 1231 gains/losses, charitable contributions, Section 179 expense deductions, dividend and interest income, foreign taxes, tax-exempt income, and Section 199A QBI components.
Section 179 expensing is subject to a two-tier statutory limitation applied first at the partnership level ($2,500,000 for 2025) and again at each partner's individual level.
Last updated: October 2026
Partnership Flow-Through Architecture & Form 1065 Overview
Under federal tax law, a partnership is not a taxable entity. Under IRC §701 , "a partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities." Instead of paying corporate income tax, the partnership functions as an informational and accounting conduit (the aggregate theory), collecting operational revenue, deducting allowable expenses, and channeling the net economic results directly to its owners.
To fulfill its reporting obligations, every domestic partnership must file Form 1065, U.S. Return of Partnership Income . Form 1065 is an annual information return due on the 15th day of the 3rd month following the close of the partnership's taxable year (March 15 for calendar-year partnerships). An automatic six-month extension to September 15 may be obtained by filing Form 7004 on or before the original due date.
Partners must report and pay tax on their distributive shares of partnership taxable items on their own returns, whether or not any cash or property is actually distributed to them . This is the fundamental hallmark of pass-through taxation: partners are taxed on profits as they are earned by the partnership, not when they are distributed.
Form 1065 Page 1: Ordinary Business Income & Allowable Deductions
Page 1 of Form 1065 is strictly reserved for the partnership's ordinary trade or business income and allowable operational deductions . Items that have statutory limitations, phase-outs, or preferential tax rates at the partner level are strictly prohibited from appearing on Page 1.
Computation of Gross Profit (Lines 1–8)
Gross Receipts or Sales (Line 1a): Total commercial sales and professional fees from ordinary business operations.
Returns and Allowances (Line 1b): Refunds, billing adjustments, and discounts.
Cost of Goods Sold (COGS) (Line 2): Calculated on Form 1125-A (Beginning Inventory + Purchases + Direct Labor + Other Costs - Ending Inventory).
Gross Profit (Line 3): Line 1c (Net Receipts) minus Line 2 (COGS).
Other Income / Loss (Lines 4–7): Ordinary operational recoveries, net farm profit/loss (Form 1040, Schedule F), and net gain/loss from Form 4797, Part II, Line 17 (ordinary sales of business property not subject to capital gain treatment).
Total Income (Loss) (Line 8): The algebraic sum of Lines 3 through 7.
Allowable Ordinary Business Deductions (Lines 9–21)
The partnership deducts its ordinary and necessary operational expenses under IRC §162 :
Line 9: Salaries and Wages: Compensation paid to non-partner employees. Compensation paid to partners can never be reported here; partners are not employees for federal tax purposes.
Line 10: Guaranteed Payments to Partners: Payments made to partners for services or capital determined without regard to partnership income under IRC §707(c) . This deduction reduces Page 1 ordinary income.
Line 11: Repairs and Maintenance: Routine upkeep and maintenance of business equipment and real property (governed by the Tangible Property Regulations under Reg. §1.263(a)-3).
Line 12: Bad Debts: Direct charge-off under IRC §166 for accrual-basis partnerships (cash-basis partnerships receive $0 bad debt deduction for uncollected service accounts).
Line 13: Rent: Lease payments for commercial facilities and equipment used in business operations.
Line 14: Taxes and Licenses: State and local property taxes, employer payroll taxes, and business operating licenses. Federal income taxes and foreign income taxes eligible for the foreign tax credit are not deductible on Page 1.
Line 15: Interest Expense: Operating business interest expense, subject to the business interest limitation under IRC §163(j) (capped at 30% of adjusted taxable income for entities with average annual gross receipts exceeding $31 million for 2025).
Line 16: Depreciation: Regular MACRS depreciation from Form 4562, Line 22. EXAM TRAP: The Section 179 expense election is strictly excluded from Line 16; Section 179 must be separately stated on Schedule K.
Line 17: Depletion: Cost or percentage depletion on natural resources.
Line 18: Retirement Plans, etc.: Contributions to qualified retirement plans for non-partner employees.
Line 19: Employee Benefit Programs: Group health, life, and accident plans for non-partner employees.
Line 20: Other Deductions: All other ordinary operating expenses (e.g., insurance, advertising, legal fees, 50% deductible business meals under §274(n)).
Line 22: Ordinary Business Income (Loss): Line 8 (Total Income) minus Line 21 (Total Deductions). This figure represents the partnership's bottom-line operational result, transferring directly to Schedule K, Line 1 .
The Conduit Principle & Separately Stated Items (IRC §702(a))
Under IRC §702(a) and IRC §703(a) , the partnership's taxable income is computed in the same manner as an individual's, subject to one critical mandate: items that could affect the tax liability of any individual partner if separately stated on that partner's return must be segregated from Page 1 and passed through separately .
Why must certain items be separately stated? Because individual partners have unique tax circumstances:
Capital gains and losses must be netted against the partner's individual capital transactions on Form 1040, Schedule D.
Charitable contributions are subject to individual Adjusted Gross Income (AGI) limitations (e.g., 60% cash ceiling under §170(b)).
Section 179 expensing is capped at both the partnership level and the partner level.
Qualified dividends qualify for preferential tax rates (0%, 15%, or 20%) rather than ordinary income brackets.
Foreign taxes can be claimed as either a deduction or a credit on Form 1116.
If these items were commingled on Page 1, their special tax characteristics, preferential rates, and statutory limitations would be lost.
Comprehensive Catalog of Separately Stated Items
The following items must bypass Page 1 and appear on Schedule K and each partner's Schedule K-1:
Schedule K Line Separately Stated Item Statutory Authority Reason Separately Stated
Line 2 Net income (loss) from rental real estate IRC §469 Passive activity rules; active participation $25,000 allowance evaluated at partner level.
Line 3 Other net rental income (loss) IRC §469 Equipment and non-real estate leasing; passive loss rules apply.
Line 4a–4c Guaranteed payments IRC §707(c) Ordinary income to recipient; subject to self-employment tax if for services.
Line 5 Interest income IRC §702(a)(7) Portfolio income; cannot be offset by passive partnership operating losses.
Line 6a Ordinary dividends IRC §702(a)(7) Portfolio income reported on partner's Schedule B.
Line 6b Qualified dividends IRC §1(h)(11) Subject to preferential long-term capital gains tax rates (0%/15%/20%).
Line 7 Royalties IRC §702(a)(7) Portfolio/investment income reported on Form 1040, Schedule E, Part I.
Line 8 Net short-term capital gain (loss) IRC §702(a)(1) Netted against individual short-term transactions on Form 8949 / Schedule D.
Line 9a Net long-term capital gain (loss) IRC §702(a)(2) Netted against individual long-term transactions; taxed at preferential rates.
Line 9b Collectibles (28%) gain (loss) IRC §1(h)(4) Subject to maximum 28% capital gains rate.
Line 9c Unrecaptured Section 1250 gain IRC §1(h)(6) Real estate depreciation recapture taxed at a maximum rate of 25%.
Line 10 Net Section 1231 gain (loss) IRC §702(a)(3) Netted at partner level on Form 4797; subject to Section 1231(c) 5-year lookback.
Line 11 Section 179 deduction IRC §179(d)(8) Two-tier statutory limit: entity level ($2,500,000 for 2025) and partner level.
Line 12 Other deductions IRC §702(a)(7) Section 59(e)(2) expenditures, commercial revitalization deductions.
Line 13a Charitable contributions IRC §702(a)(4) Cash (up to 60% AGI) and non-cash property subject to individual AGI limits.
Line 14a Net earnings from self-employment IRC §1402(a) General partners pay SE tax on Line 1 ordinary income + guaranteed payments for services.
Line 15 Credits IRC §702(a)(7) Research credit (§41), Low-Income Housing Credit (§42), Work Opportunity Credit (§51).
Line 16 Foreign transactions IRC §702(a)(6) Foreign gross income, foreign taxes paid/accrued (Form 1116/1118 credit vs. deduction).
Line 17 Alternative Minimum Tax (AMT) items IRC §56–§58 Depreciation adjustments, private activity municipal bond interest, mine development costs.
Line 18a Tax-exempt interest income IRC §705(a)(1)(B) Non-taxable municipal bond interest; increases partner's outside basis.
Line 18c Nondeductible expenses IRC §705(a)(2)(B) 50% nondeductible meals, fines, penalties, political contributions; reduces outside basis.
Line 20 Other information (QBI / §199A) IRC §199A QBI ordinary items, W-2 wages, UBIA of qualified property, and Section 199A dividends.
Schedule K (Partnership Summary) vs. Schedule K-1 (Partner Distributive Share)
Form 1065 includes two critical schedules that bridge the entity and its owners: Form 1065, Page 1 (Ordinary Business Operations)
- │
- ├─ Line 22 Ordinary Income ─────────► Schedule K, Line 1 (Entity Total)
- │
- Non-Page 1 Items (Capital gains, 179, etc.) ──► Schedule K, Lines 2–20 (Entity Totals)
- │
- ▼
- Allocated via Partnership Agreement
- │
- ┌───────────────────────────────┴───────────────────────────────┐
- ▼ ▼
- Partner A Schedule K-1 Partner B Schedule K-1
- (Distributive Share of All Items) (Distributive Share of All Items)
Schedule K: A summary schedule on Pages 4–5 of Form 1065 that reports the entire partnership's aggregate totals for both ordinary business income and all separately stated items.
Schedule K-1: An individual partner form filed with the IRS and furnished to each partner. It details each partner's specific distributive share of every Schedule K item.
Allocating Items: Section 704(a) vs. Section 704(b)
Under IRC §704(a) , a partner's distributive share of income, gain, loss, deduction, or credit is determined by the partnership agreement . The agreement may provide for "special allocations" (e.g., allocating 80% of depreciation to Partner A and 20% to Partner B) rather than allocating strictly by capital ownership percentages.
However, under IRC §704(b) , special allocations are respected for tax purposes only if they have substantial economic effect (SEE) :
Economic Effect: The allocation must actually affect the dollar amount the partner receives upon liquidation. Under Treas. Reg. §1.704-1(b)(2), the partnership must:
- Maintain capital accounts according to §704(b) tax accounting rules;
- Liquidate according to positive capital account balances; and
Impose an unconditional Deficit Restoration Obligation (DRO) or include a Qualified Income Offset (QIO) .
Substantiality: The economic effect must be substantial; an allocation is invalid if it merely shifts tax liabilities among partners without substantially altering the pre-tax economic consequences (e.g., allocating all tax-exempt income to a partner in a 37% tax bracket and all taxable income to a partner with net operating loss carryforwards).
If an allocation lacks substantial economic effect, the IRS will reallocate the items in accordance with the Partner's Interest in the Partnership (PIP) , considering capital contributions, economic risk of loss, and rights to distributions upon liquidation.
Section 179 Two-Tier Limitation Mechanics
The Section 179 expense election illustrates how separately stated items interact with statutory limitations. For Tax Year 2025 , the maximum Section 179 expense deduction is $2,500,000 , with a dollar-for-dollar phase-out threshold starting at $4,000,000 of qualifying equipment placed in service.
Under IRC §179(d)(8) , the dollar ceiling and phase-out rules are enforced at both tiers :
Tier 1 (Partnership Level): The partnership elects Section 179 on Form 4562. If the partnership places $4,500,000 of qualifying equipment in service during 2025, its maximum deduction is reduced by $500,000 ($4,500,000 - $4,000,000), leaving $2,000,000 allowable on Schedule K, Line 11.
Tier 2 (Partner Level): The partnership allocates the $2,000,000 to partners on Schedule K-1, Box 11. Each partner combines their share from all partnerships with their own sole proprietorship Section 179 elections. The partner's total aggregate Section 179 deduction cannot exceed the 2025 ceiling of $2,500,000 , nor can it exceed the partner's aggregate active business taxable income.
Comprehensive Worked Example: Form 1065 vs. Schedule K / K-1
Scenario: Pinnacle Consulting Partnership has two equal 50/50 general partners, Alex and Brenda. Pinnacle's records for Tax Year 2025 reflect the following financial data:
- Gross receipts from client billings: $900,000
- Client refunds and billing adjustments: $20,000
- Cost of hardware products sold (COGS): $240,000
- Salaries paid to non-partner technical staff: $160,000
- Guaranteed payment to Alex for managing firm operations: $60,000
- Office lease payments: $48,000
- MACRS depreciation on equipment (Form 4562, Line 22): $32,000
- Section 179 expense elected on qualifying equipment: $40,000
- Advertising and business promotion: $18,000
- Business meals with clients (total expenditure $12,000; 50% deductible = $6,000; 50% nondeductible = $6,000)
- State and local business franchise taxes: $6,000
- Charitable cash contributions to the American Red Cross: $14,000
- Net long-term capital gain from selling investment shares: $24,000
- Net Section 1231 gain from selling a business delivery van: $10,000
- Qualified dividend income from stock portfolio: $8,000
- Tax-exempt interest income from municipal bonds: $5,000
- Step 1: Compute Page 1 Ordinary Business Income (Line 22)
- Gross Profit (Line 3): Net Receipts ($900,000 - $20,000 = $880,000) minus COGS ($240,000) = $640,000
Total Ordinary Deductions (Line 21):
- Salaries and wages (Line 9): $160,000
- Guaranteed payment to Alex (Line 10): $60,000
- Rent expense (Line 13): $48,000
- Taxes and licenses (Line 14): $6,000
- MACRS depreciation (Line 16): $32,000
- Advertising (Line 20): $18,000
- 50% Allowable meals (Line 20): $6,000
Total Allowable Ordinary Deductions: $160,000 + $60,000 + $48,000 + $6,000 + $32,000 + $18,000 + $6,000 = $330,000
Ordinary Business Income (Line 22): $640,000 minus $330,000 = $310,000
(Notice that Section 179, charitable donations, capital gains, §1231 gains, qualified dividends, municipal interest, and nondeductible meal portions were completely excluded from Page 1).
- Step 2: Schedule K Entity Totals
- Line 1: Ordinary business income: $310,000
- Line 4a: Guaranteed payments for services: $60,000
- Line 6b: Qualified dividends: $8,000
- Line 8: Net long-term capital gain: $24,000
- Line 9a: Net Section 1231 gain: $10,000
- Line 11: Section 179 deduction: $40,000
- Line 13a: Charitable contributions: $14,000
- Line 18a: Tax-exempt interest income: $5,000
- Line 18c: Nondeductible expenses (50% meals): $6,000
- Step 3: Alex's Schedule K-1 (50% Partner)
- Box 1: Ordinary business income: 50% × $310,000 = $155,000
- Box 4a: Guaranteed payments for services: $60,000 (allocated 100% to Alex pursuant to agreement)
- Box 6b: Qualified dividends: 50% × $8,000 = $4,000
- Box 8: Net long-term capital gain: 50% × $24,000 = $12,000
- Box 9a: Net Section 1231 gain: 50% × $10,000 = $5,000
- Box 11: Section 179 deduction: 50% × $40,000 = $20,000
- Box 13: Charitable contributions: 50% × $14,000 = $7,000
Box 14: Self-employment earnings: Box 1 ($155,000) + Box 4a ($60,000) = $215,000 (as a general partner, Alex pays SE tax on both)
- Box 18a: Tax-exempt interest: 50% × $5,000 = $2,500 (increases Alex's outside basis)
- Box 18c: Nondeductible expenses: 50% × $6,000 = $3,000 (reduces Alex's outside basis)
- Common Exam Traps & Pitfalls
The Section 179 Page 1 Error: Candidates frequently mistake Section 179 for standard depreciation and deduct it on Form 1065, Page 1, Line 16. Regular MACRS depreciation goes on Line 16; Section 179 is always separately stated on Schedule K, Line 11.
Charitable Contributions on Page 1: A partnership can never deduct charitable donations against ordinary business income. Charitable contributions are always separately stated on Schedule K, Line 13a.
Guaranteed Payment Dual Reporting: Guaranteed payments are deducted on Form 1065, Page 1, Line 10 (reducing ordinary income), but they must also be reported on Schedule K, Line 4, and on the recipient partner's Schedule K-1, Box 4a. Candidates often forget the deduction step on Page 1.
Tax-Exempt Income Basis Impact: Tax-exempt interest is not taxable, but candidates forget that it increases the partner's outside basis under IRC §705(a)(1)(B). If it did not increase basis, the partner would be taxed on the tax-exempt income when they subsequently distribute the cash or sell the partnership interest!