Tax Due Diligence Checklist
Partnership Tax Due Diligence Checklist
Tax review items for general partnerships, limited partnerships, LLPs, and any LLC taxed as a partnership. Partnership tax has more anti-abuse rules and partner-level mechanics than any other entity, and they all show up in diligence.
Why a Partnership-Specific Checklist
- •Hot asset rules (Section 751) can convert capital gain to ordinary income on a partner's exit, often surprising sellers.
- •704(c) layers persist for the life of the partnership and follow assets through subsequent transactions.
- •Disguised sale rules (Section 707) recharacterize contributions paired with distributions and can blow up planned transactions.
- •The BBA partnership audit regime shifts audit liability to the partnership unless careful elections are made.
The Checklist
Items a buyer or seller in a partnership transaction should expect to request, produce, or review.
1. Partnership Agreement and Allocation Provisions
Current partnership agreement and all amendments
All versions of the agreement since formation, with effective dates of any amendments.
Allocation provisions (income, loss, deductions, credits)
Specific paragraphs governing each allocation and any special allocations.
Substantial economic effect or PIP analysis
Whether allocations have substantial economic effect under 704(b) or are otherwise in accordance with the partners' interests in the partnership.
Capital account maintenance language
Whether the agreement requires capital account maintenance under Treasury Regulation 1.704-1(b).
Distribution waterfalls and preferred returns
Targeted allocations or layer-cake provisions; reconciliation to actual cash distributions.
Partner admission and withdrawal provisions
How new partners are admitted, how withdrawing partners are paid, and tax consequences of each.
2. Federal Returns and Workpapers
Form 1065 for last 4-6 years with all schedules and K-1s
Complete returns including Schedule K, K-1s, M-1, M-2, M-3, and partner capital roll-forwards.
Schedules K-2 and K-3 (international items)
If filed, with supporting partner-level workpapers.
Allocation workpapers tying K-1s to Schedule K
How each line of K was allocated to each partner.
Section 704(b) capital account roll-forward by partner
Beginning balance, contributions, distributions, allocations of income and loss, and ending balance.
Tax basis capital reporting (now required)
Partner tax basis schedules in the format required since 2020 reporting changes.
Reconciliation between book capital, tax capital, and outside basis
Three-column reconciliation by partner. Differences between these are normal but should be explainable.
3. Hot Assets and Inventory (Section 751)
Section 751 recharacterizes a portion of any sale of a partnership interest as ordinary income to the extent the partnership holds hot assets.
Inventory items at fair value vs. tax basis
Substantial appreciation analysis for 751(b) purposes.
Unrealized receivables (depreciation recapture potential)
Section 1245 and 1250 recapture inherent in depreciable property.
Section 751(a) calculation for any partner exits
Per-partner calculation of ordinary income recharacterization on transfer.
Section 751(b) tracking on disproportionate distributions
Distributions of hot assets vs. cold assets that change a partner's relative interest.
Cash basis accounts receivable
If the partnership uses the cash method, A/R are unrealized receivables and trigger 751.
4. 704(c) and Built-In Gain Layers
Schedule of all property contributions since formation
Date of contribution, fair value at contribution, tax basis at contribution, and built-in gain or loss.
Method elected for each contribution
Traditional, traditional with curative, or remedial. Method is generally property-by-property.
Remaining 704(c) layer schedule by property
How much built-in gain or loss has been recognized to date and what remains.
Reverse 704(c) tracking
From revaluations of partnership property when capital accounts are booked up or down.
Anti-abuse considerations
Mixing-bowl partnerships, ceiling rule shifts, anti-abuse application under 1.704-3.
5. Disguised Sales and Section 707 Issues
Contributions and distributions within two years of each other
Each direction tested against the disguised sale rules.
Debt-financed distributions
Whether new partnership debt was followed by distributions, with debt-financed transfer analysis.
Leveraged contributions
Property contributed subject to debt, with relief of debt allocations.
Section 707(a) payments treated as services or property transfers
Distinct from guaranteed payments, with character implications.
Section 707(c) guaranteed payments
Payment amounts, character (services vs. capital), and consistency across years.
6. Section 754 Elections and Basis Adjustments
Section 754 election history
Date originally made, any revocations, and current status.
Section 743(b) basis adjustments by transfer
Each transfer of a partnership interest, with basis adjustment computation and allocation among partnership assets under Section 755.
Section 734(b) adjustments
Basis adjustments triggered by distributions, with supporting computations.
Mandatory adjustments under 743(d) and 734(d)
Substantial built-in loss and substantial basis reduction triggers, even without a 754 election.
7. Section 752 Liability Allocations
Recourse, qualified non-recourse, and non-recourse classification
Each material liability classified, with supporting analysis.
Partner-by-partner allocation schedule
How each liability category is allocated under Section 752 regulations.
Constructive liquidation analysis for recourse debt
Treas. Reg. 1.752-2 analysis identifying which partner bears economic risk.
Significant changes in debt allocations
Refinancings, new debt, debt paydowns and the partner-level consequences.
8. BBA Partnership Audit Regime
Partnership representative for each year
Designated PR, contact information, and authority.
Section 6221(b) opt-out elections
If the partnership had 100 or fewer K-1s and all eligible partners, any opt-out elections made.
Push-out and pull-in elections
Section 6226 push-out elections in any prior audit; pull-in payments under 6225(c).
Pending audits, NOPPAs, and FPAs
Notices of Proposed Partnership Adjustment, Final Partnership Adjustments, and any open examinations.
AAR (administrative adjustment requests) filed
Partnership-level amended return equivalents under the BBA regime.
9. Multi-State Issues
Composite return and pass-through entity tax (PTET) elections
By state and year. PTET elections affect the SALT cap workaround and partner-level outcomes.
Withholding for non-resident partners
Each state's nonresident withholding rules applied to applicable partners.
State nexus and apportionment by year
Where the partnership has nexus, with apportionment computations and reasonableness review.
Sales and use tax exposure
Wayfair compliance, registration status, and any unfiled exposure.
10. Special Items
Section 199A QBI flow-through
Per-partner W-2 wages, UBIA, SSTB classification, and aggregation elections.
Section 163(j) interest expense limitation
Partnership-level computation, allocation to partners, and excess business interest carryovers.
Foreign filings (Forms 8865, 5471, 5472)
Any foreign partners, foreign branches, or controlled foreign affiliates.
Carried interest and Section 1061 holding period rules
If applicable to investment fund partnerships.
Section 1202 QSBS
Generally not available for partnership interests, but document any pass-through QSBS positions.
Frequently Asked Questions
Why is partnership tax DD more complex than corporation tax DD?
Partnerships have partner-level tax mechanics that corporations do not: capital accounts, outside basis, special allocations, hot asset recharacterization, 704(c) layers, 752 liability allocations, and disguised sale rules. Each of these can produce surprises at exit. Corporations have one taxpayer (the entity, or the shareholder if pass-through) and a much simpler set of mechanics.
What is a Section 751 hot asset issue?
Section 751 says that when a partner sells their partnership interest, any portion of the gain attributable to inventory and unrealized receivables is treated as ordinary income, not capital gain. For a service-based partnership with cash basis A/R, or for a partnership with fully depreciated equipment, hot assets can be a meaningful piece of the deal. The seller does not always realize this until the K-1 arrives the year after closing.
What is the BBA partnership audit regime and why does it matter?
Since 2018, the IRS audits partnerships at the partnership level (under the BBA, Bipartisan Budget Act). The partnership pays the tax on any adjustment unless it makes a push-out election to pass the adjustment back to historical partners. For a partnership that gets audited after a sale, this means new partners can end up paying tax on issues that arose before they bought in, unless the purchase agreement allocates that risk properly.
Should I worry about the disguised sale rules?
If your partnership has had any contributions paired with distributions within a two-year window, especially debt-financed distributions, the disguised sale rules deserve attention. They can recharacterize a planned tax-free contribution and distribution as a taxable sale. This is one of the most common surprises in partnership-side diligence.
Does this checklist apply to LLCs taxed as partnerships?
Yes. Any LLC with two or more members that has not elected corporate treatment is taxed as a partnership and follows the partnership rules in full. Use this checklist alongside the LLC tax DD checklist for entity-level items specific to LLCs.
Pillar Pages
Sell-Side Tax Due Diligence
For family business owners going to market. Surface and fix tax exposures before a buyer finds them and discounts your price.
Buy-Side Tax Due Diligence
For small businesses growing through acquisition. Understand what you are buying, who carries the exposure, and how to structure the deal.