The IRS has updated its practice unit on Partner’s Outside Basis. The overview is as follows:
A partnership is a relationship between two or more persons who join together to carry on a trade, business, or investment activity. Each partner has a basis in his partnership interest. The partner’s basis in his partnership interest is separate from the partnership’s basis in its assets. Partnership tax law often refers to “outside” and “inside” basis. Outside basis refers to a partner’s interest in a partnership. Inside basis refers to a partnership’s basis in its assets. Publication 541 contains information on outside basis. This Practice Unit focuses on key concepts you must understand in order to properly calculate outside basis.
The rules regarding the computation of outside basis apply to all types of partners including general partners, limited partners, and limited liability company (LLC) members. The rules apply to entities which are treated as partnerships for federal income tax purposes including general partnerships, limited partnerships, publicly traded partnerships, limited liability partnerships and limited liability companies (which have at least two owners and which do not elect to be treated as a corporation).
A partner may hold both a general and a limited partnership interest in the same partnership. In this case, the partner is considered to have only one unitary basis equal to the combined interests. Rev. Rul. 84-52. Note that the owner of a disregarded entity has no outside basis in the entity for federal income tax purposes.
Computing a partner’s outside basis is necessary when determining:
– The maximum amount of any deduction or loss that passes through to the partner,
– The gain or loss from the disposition of a partnership interest,
– The tax consequences of cash distributions, and
– The tax consequences of property distributions.
Nature of Partnerships
Subchapter K of the Internal Revenue Code addresses rules regarding the taxation of partnerships and partners. Certain aspects of Subchapter K are governed by the “aggregate theory” which views the partnership as a collection of its partners. Other aspects are governed by the “entity theory” which treats the partnership as a “taxpayer,” even though it pays no tax. For example, partnerships function as entities when a tax year and a method of accounting are chosen. It is the partnership that selects the tax year and method of accounting, not each partner. Most elections are made by the partnership. The concept that each partner must track a basis in his partnership interest reflects the entity view of partnerships.
A partnership is called a “flow-through entity” or a “pass-through entity.” Partnerships pay no tax. Rather, each partner includes his share of the partnership’s income, gain, loss, deduction, or credits on his personal tax return. Therefore, for purposes of reporting tax items and calculating tax liabilities, the partnership is treated as an aggregate of its partners.
As previously stated, outside basis is a partner’s basis in his partnership interest. Inside basis is the partnership’s basis in its assets. Typically, at the start of the partnership, the sum of each partner’s outside basis equals the partnership’s inside adjusted tax basis in its assets. The reason for this equality is the accounting equation Assets equal Liabilities plus Owners’ Equity. In the partnership context, this is phrased as Assets equal Liabilities plus Partners’ Capital Accounts. The partnership’s assets were either contributed by the partners, purchased with contributed cash or earned income, or purchased with money the partnership borrowed.
There are three common reasons why the equality between inside and outside basis may change:
- Acquisition of a partnership interest other than by contribution.
- Gain or loss recognized by a partner on a distribution.
- Decrease in the basis of an asset of the partnership on a current distribution or an increase in the basis of a partnership asset on a liquidating distribution (excluding 732(d) application).
If a partnership made a section 754 election, a partner’s outside basis can be estimated by added his tax basis capital account, his share of liabilities, and his section 743(b) basis adjustments which can be found on the Schedule K-1 (Form 1065).
Outside Basis and Inside Basis
A partner’s outside basis in his partnership interest can be estimated by adding his tax basis capital account, his share of liabilities, and his section 743(b) basis adjustments (if the partnership made a section 754 election). An increase in a partner’s share of partnership liabilities is treated as a contribution of money by the partner to the partnership and thus increases his outside basis. A decrease in a partner’s share of partnership liabilities is treated as a distribution of money to the partner and thus decreases his outside basis. IRC 752(a) and (b). Each partnership liability is part of at least one partner’s outside basis. Rules concerning the definition of partnership liabilities are covered in the Determining Liability Allocations Concept Unit. Rules for allocating partnership liabilities among the partners are covered in the Determining Liability Allocations Concept Unit.
While a partner’s capital account may be negative (due to allocated losses and distributions), a partner’s outside basis may never be a negative number. A partner whose capital account is negative may still have a positive basis in his partnership interest because his share of partnership liabilities is greater than his negative capital account.
Capital Account Overview
Capital accounts increase or decrease every year. If the partnership is profitable, the partner’s distributive share of profits increases his capital account. If the partnership generates a loss, then the partner’s distributive share of the loss decreases his capital account. Additionally, a partner’s contributions of cash or property increase his capital account. Conversely, a partnership’s distribution of cash or property to the partner decreases his capital account.
A partner may have a negative capital account. However, a partner may never have a negative outside basis. A partner whose capital account is negative may still have a positive basis if his share of partnership liabilities exceeds his negative capital account. The four types of capital accounts are:
- Section 704(b) Book.
- Generally Accepted Accounting Principles (GAAP).
- Tax Basis.
Impact of Partnership Operations on Partnership Outside Basis
A partner’s basis in his partnership interest increases or decreases each year depending on a variety of factors. The following items increase outside basis:
– An increase in the partner’s share of either recourse or nonrecourse liabilities. IRC 752(a).
– A partner’s contributions of property or money including an increased share of, or assumption of, partnership liabilities. IRC 722.
– The partner’s share of taxable partnership income, including capital gains. IRC 705(a)(1)(A).
– The partner’s share of tax-exempt income. IRC 705(a)(1)(B).
– The partner’s share of percentage depletion deductions exceeding the adjusted basis in depletable property. IRC 705(a)(1)(C).
The follow items decrease outside basis:
– A decrease in the partner’s share of partnership liabilities. IRC 752(b).
– Distributions of money (including a decreased share of partnership liabilities or an assumption of the partner’s individual liabilities by the partnership) and property distributed to the partner by the partnership. IRC 733 and IRC 732.
– The partner’s share of partnership losses, including capital losses. IRC 705(a)(2)(A).
– The partner’s share of expenses that are neither deductible nor capitalized for income tax purposes. IRC 705(a)(2)(B).
– The partner’s share of depletion from oil and gas properties. IRC 705(a)(3).
Partner’s Initial Outside Basis
A partner may acquire an interest in a partnership in a variety of ways. For example, the partner may purchase his interest from an existing partner. Like any other asset, a partnership interest may be acquired through a gift or an inheritance. Additionally, a partner may contribute property and/or cash in exchange for a partnership interest. Lastly, a partner may contribute services in exchange for a partnership interest. The partner’s initial outside basis depends on how the interest was acquired.
The basis of a partnership interest acquired by contribution is the amount of cash plus the adjusted basis of any contributed property. IRC 722. Generally, a partner does not recognize gain or loss upon contributions of property to a partnership in exchange for a partnership interest. IRC 721. Instead, the contributing partner’s basis in the property becomes the partnership’s basis. IRC 723.
A partner’s holding period in a partnership interest received for a property contribution depends on the type of property contributed. If the property contributed for the interest was a capital asset or an IRC 1231 asset, the holding period of the partnership interest will include the holding period of the contributed assets. If a partner contributes any other property or money, his holding period will begin on the day after the interest is acquired. If a combination of property is contributed, the holding period of the partnership interest will be split.
When a partner buys a partnership interest from an existing partner, the purchasing partner’s initial outside basis is the consideration paid to the seller (cash plus the value of any property) plus his share of partnership liabilities assumed. IRC 742 and IRC 1012. When a partnership interest is acquired by gift, the partner’s outside basis will generally be the outside basis of the donor. IRC 742 and IRC 1015. The basis of an inherited partnership interest equals the fair market value of the partnership interest at the decedent’s date of death or the alternate valuation date, if applicable. IRC 1014.
As previously stated, a partner may acquire a partnership interest in exchange for contributing cash or property. Additionally, a partner may contribute services in exchange for a partnership interest. The impact on the partner’s outside basis depends on whether the partner recognizes compensation income for the services performed. This, in turn, depends on the type of interest received (a capital interest or a profits interest). Under Treas. Reg. 1.721-1(b)(1), the receipt of a vested partnership capital interest in exchange for services is taxable as compensation. An interest is vested if it is either transferable or not subject to a substantial risk of forfeiture. The partner’s outside basis is increased by the amount of the compensation income recognized.
Unless an exception is met, a partner who contributes services to a partnership in exchange for a profits interest does not recognize compensation income. Therefore, the transaction has no impact on the partner’s outside basis. Revenue Procedure 93-27, 1993-2 C.B. 343 and Rev. Proc. 2001-43 address the receipt of a partnership profits interest when services are provided to or on behalf of the partnership.
Under Rev. Proc. 93-27, the grant of a profits interest to a service partner is generally not a taxable event. However, under the following three exceptions, a partner who contributes services in exchange for a profits interest must recognize income:
- The partner disposes of the interest within two years of its receipt;
- The partnership units are publicly traded; or
- The profits interest relates to a “substantially certain and predictable stream of income from partnership assets.”
A partner’s equity equals the amount of money or property the partner would receive if the partnership liquidated. A partner’s outside basis includes a partner’s share of liabilities whereas a partner’s capital account does not (Assets minus Liabilities equals Capital). When performing a risk analysis, adding the capital account as reported on the Schedule K-1, allocable share of liabilities, and any IRC 743(b) adjustments allows for an estimation of the partner’s outside basis. As noted throughout this unit, the accuracy of this estimation depends on whether the capital accounts on the Schedule K-1 are reported on a tax basis.
Prior to 2020, a partnership could choose the method for reporting a partner’s capital account. It could select (1) section 704(b) book; (2) GAAP; (3) tax basis; or (4) other.
Prior to 2020, the partnership had to check the appropriate box that described the method of accounting used to figure the partner’s capital account for reporting purposes on each Schedule K-1 in Section L. If the method of accounting used to figure the partnership’s capital account was based on the partnership’s income and deductions for federal income tax purposes, the “Tax basis” box had to be checked. On the other hand, the “GAAP” box had to be checked if the figure was determined based on generally accepted accounting principles (GAAP). If the partnership arrived at the figure based on the capital accounting rules under Treas. Reg. 1.704-1(b)(2)(iv), the “Section 704(b) book” box had to be checked. If none of the three methods named above (tax basis, GAAP, or Section 704(b) book) were used, the “Other” box had to be checked, and the partnership had to attach a statement describing the method and showing how the partner’s capital account was determined.
Tax Basis Capital Account
As its name implies, the tax basis capital account is based on tax accounting. The tax basis capital account is increased by the adjusted tax basis of the contributed assets (net of liabilities) and decreased by the adjusted basis of assets distributed (net of liabilities). Second, the tax basis capital account is increased or decreased annually by increases and decreases as reflected on the partners’ Schedules K-1 Part III and attached statements. Tax gain or loss on the sale or other disposition of partnership property is computed using the asset’s tax basis. A partner’s tax basis capital account plus his share of partnership liabilities plus his section 743(b) adjustment (assuming that the partnership made a section 754 election) generally equals his outside basis in his partnership interest. Note: The accuracy of this computation may be materially reduced if the partnership did not make a section 754 election.
IRC 704(b) Book Capital Accounts
The IRC 704(b) book capital accounting system is a creation of the partnership regulations. It is important to distinguish these “IRC 704(b) book capital accounts” from tax or GAAP capital accounts. The purpose of IRC 704(b) book capital is to reflect each partner’s economic share of the partnership’s assets equal to their equity in the partnership.
The rules for computing and maintaining book capital accounts are found in Treas. Reg. 1.704-1(b)(2)(iv)(b), a regulation section supporting IRC 704(b). For that reason, such capital accounts are known as “704(b) book” capital accounts. This term can be confusing because the accounting profession often equates the term “book” with financial accounting principles. Maintenance of IRC 704(b) book capital accounts are often included into partnership agreements to satisfy the safe harbor for economic effect as well as to assist in determining whether a partner’s allocation has economic effect. Treas. Reg. 1.704-1(b).
IRC 704(b) book capital accounts use fair market value for property contributions and property distributions. For example, if two individuals desire to form a 50/50 partnership, they agree as to the amount of money and the value of property each must contribute so their interests are equal. Professional appraisals may be obtained to value the property or services contributed.
A partner’s book capital is increased/decreased by his allocable share of partnership book income/loss for the year, including taxexempt income. The tax character of the income or loss is not relevant, capital gain and ordinary income are treated the same. IRC 704(b) book income/loss is the same as taxable income/loss with three adjustments. First, depreciation deductions are computed by using tax depreciation concepts (that is, life method) applied to the book basis of assets. Second, gain/loss on an asset sale is computed by using the adjusted book basis of the disposed asset. Third, any inherent gain/loss in the distribution of property to a partner must be allocated to all partners in accordance with their allocation arrangement immediately prior to the distribution. A partnership agreement may, upon the occurrence of certain events, increase or decrease the book capital accounts of the partners to reflect a revaluation of partnership property (including intangible assets such as goodwill) on the partnership’s books. Treas. Reg. 1.704-1(b)(2)(iv)(f).
In general, a partner’s distributive share of partnership loss, including capital loss, is allowed only to the extent of the partner’s outside basis. IRC 704(d). In determining the extent to which loss or deduction may be claimed, the partner’s outside basis is first increased by his share of income, contributions, and liabilities, and decreased by both cash and property distributions and any decrease in his share of partnership liabilities. IRC 705. If the current year aggregate loss exceeds the adjusted outside basis, the loss limitation must be allocated to each type of loss or deduction, including any amounts carried over from prior years due to previous basis limitations. Treas. Reg. 1.704-1(d)(2).
The Tax Cuts and Jobs Act (TCJA) amended IRC 704(d). IRC 704(d)(3)(A) provides that charitable contributions and foreign tax payments are taken into account under the basis limitation rules. Under prior law, a partner could take into account their entire distributive shares of charitable contributions or foreign tax payments even if they were in excess of outside basis.
Under TCJA, for partnership tax years beginning after December 31, 2017, a partner may not take into account his distributive share of foreign tax payments if the amount of the payments exceed his outside basis. The new rule for charitable contributions is more complicated. New IRC 704(d)(3)(B) addresses situations in which a partnership donates built-in gain property, in other words, property whose fair market value exceeds its tax basis. Partners must reduce outside basis by their share of the appreciated property’s tax basis. The donated property’s built-in gain does not reduce outside basis and is not subject to IRC 704(d).
Posted by Jessica Ji, Associate Editor, Wealth Strategies Journal.