Planning on acquiring, disposing of, or otherwise changing your ownership interest in a partnership?

If so, what may seem a pretty straightforward transaction becomes much more complex in terms of the financial and tax implications for all partners involved. As a partner or potential partner, it’s critical to understand the IRS’ rules—including options that can drastically alter the amount of income or loss you’re allocated for tax purposes.

Wait until it’s time to prepare your tax return for the year and it’s too late to make positive choices.


Each partner’s annual share of a partnership’s income and gains/losses, as well as deductions and credits, is typically governed by the partnership agreement. For tax purposes, the allocation generally must follow the economics and all tax items must be allocated to partners.

That said, if at least one partner’s interest in the partnership changes during the year, the partnership must follow one of two IRS-approved allocation methods (interim closing or proration, as explained below). The choice of method can have a major impact on the partners’ financial return from the partnership, and thus on their tax liabilities.

Your partnership interest changes during the year if you sell your interest, in whole or in part, or if the partnership adds a new partner and dilutes your interest. The tax rules refer to such changes as variations in a partner’s interest in a partnership.

The current IRS rules are effective for partnership tax years that began on or after August 3, 2015.

Methods for Allocating Income

Generally, when there’s a change in one or more partnership interests during a year, the variation creates a segment, or distinct time period, within the partnership’s tax year on which to base income allocations.

One variation turns the single tax year into two distinct segments, split based on the actual date of the variation. For example, if a calendar-year partnership admits a new partner on June 30, diluting the interests of the other partners, its first segment extends from January 1 through June 30 and the second from July 1 through December 31.

Additional variations in partnership interests result in additional segments. And each variation can adopt a different method.

Interim Closing Method

Absent an agreement by all partners, the interim closing method is the default method.

Under the interim closing method, the partnership actually closes its books on the date of the variation in partnership interests and allocates income or loss based on the resulting segments. That means, for example, based on timing, one segment could actually allocate a capital loss even if the partnership claims a net capital gain for the year as a whole.

Proration Method

The proration method simply allocates your share of partnership income or loss based on the total number of days you’re a partner during the year, or the proration period.

Example Comparing the Interim Closing and Proration Methods

At the beginning of the year, Jim owns 40 percent of JB Partnership and Bill owns the remaining 60 percent. On June 30, Jim sells half of his interest to Anne. After the sale, Jim owns 20 percent, Anne owns 20 percent and Bill’s ownership interest remains at 60 percent.

During the year, the partnership earned ordinary income of $1,000,000, with $750,000 of the income earned in the second half of the year. The partnership also recognized a capital gain of $500,000 on August 1.

The total income for the year, including both ordinary income and capital gain, differs dramatically for Jim and Anne under the two methods. If the partnership uses the interim closing method, Jim is allocated $100,000 less than he would under the proration method — and Anne is allocated $100,000 more.*

Interim Closing Method

Jim Bill Anne
Ordinary income $250,000 $600,000 $150,000
Capital gain $100,000 $300,000 $100,000
Total Income $350,000 $900,000 $250,000

Proration Method

Jim Bill Anne
Ordinary income $300,000 $600,000 $100,000
Capital gain $150,000 $300,000 $50,000
Total income $450,000 $900,000 $150,000

Applying the Rules

As noted, your partnership doesn’t have to use the same allocation method for all variations throughout the year. For each variation in partnership interest, the partnership can choose to use either the interim closing method or the proration method, regardless of how many variations occur during the year.

The Interim Closing Method

After selecting the segment convention, the partnership’s items for the year are allocated among its segments. Jim’s sale of half of his ownership interest splits the year into two segments.

In the example above, for the January 1 through June 30 segment, the $1 million in ordinary income is allocated to Jim based on his ownership interest of 40 percent for the first segment’s income ($250,000) plus 20 percent for the second segment’s income ($750,000). As Bill’s ownership interest doesn’t change during the year, he is allocated 60 percent of the full $1 million. Anne joined at the beginning of the second segment, so she is allocated 20 percent of second-segment income, or $150,000.

The $500,000 in capital gain is allocated based only on second-segment ownership, as the underlying event occurred on August 1.

The Proration Method

Under the proration method, allocations are based on the actual number of days in the proration period(s).

In the example above (not a leap year), Jim had a 40 percent partnership interest for 181 days and a 20 percent interest for 184 days. His income allocation is $300,000, or (181/365 * 0.4) + (184/365 * 0.2) x $1,000,000). The result is $50,000 more than under the interim closing method because the proration method does not take into consideration when the income was earned. The fact that three-quarters of the income (and all of the capital gain) was earned in the second half of the year was not a factor in the calculation.

Exceptions to the Allocation Rules

Your partnership is not required to use either of these allocation methods if the varying interest is a result of one of two following exceptions.

Contemporaneous Partner Exception

This exception exists in order to permit interest shifts among partners who were members of the partnership for the entire tax year.

Service Partnership

This exception applies to partnerships in which capital is not a material income-producing factor. The partnership can use any reasonable method to allocate partnership items, as long as the allocations satisfy the general tax rules for a partner’s distributive share.

Treatment of Extraordinary Items

The IRS identified a number of items to be considered extraordinary, grouped by classes of extraordinary items. Regardless of the allocation method your partnership is using, extraordinary items must be allocated among all partners in proportion to their interests on the day and at the time the extraordinary item occurred.

In addition to things like disposition or abandonment of a capital asset or the settlement of a tort or similar third-party liability, extraordinary items can include any item the partners agree to consistently treat as extraordinary for that year, unless it would result in a substantial distortion of income.

De Minimis Rule: Exceptions for Small Items

To reduce the administrative burden, there is a de minimis rule that excludes small items from treatment as extraordinary items.

This exception applies if the total of all items in an extraordinary-item class represent less than five percent of a partnership’s gross income (for income and gain items) or gross expenses and losses (in the case of loss and expense items).

Further, the total extraordinary items from all classes of extraordinary items that satisfy the five percent test cannot exceed $10 million in the taxable year, determined by treating all such extraordinary items as positive amounts.

* Numbers throughout have been rounded for simplicity



If your partners are changing this year,
make sure you know the tax rules that will affect you.

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