What is a partners basis in a partnership?
2022-02-23Whether earnings are retained in a partnership or distributed to partners has no effect on the taxation of those earnings, since the partners have to pay tax on the earnings whether they are distributed or not. Earnings are distributed to each partner's capital account from which distributions are charged against. However, certain types of distributions and any distributions exceeding the partner's basis may result in gains or losses that must be reported for the year when they occur. Show
To understand the taxation of partnerships and distributions, it is necessary to know the 2 types of tax bases concerning partnerships. The inside basis is the partnership's tax basis in the individual assets. The outside basis is the tax basis of each individual partner's interest in the partnership. When a partner contributes property to the partnership, the partnership's basis in the contributed property = its fair market value (FMV). However, the outside basis of the partner increases only by the amount of the basis the partner had in the property. Example: Inside and Outside Basis
There are 2 types of distributions: a current distribution decreases the partner's capital account without terminating it, whereas a liquidating distribution pays the entire capital account to the partner, thereby eliminating the partner's equity interest in the partnership. Generally, losses are only recognized in a liquidating distribution. Cash DistributionsNo gain is recognized from a distribution of cash or marketable securities easily convertible to cash, unless the distribution is more than the partner's outside basis, in which case, the excess is taxable as a capital gain. Capital Gain = Cash Distribution – Partner's Outside Basis Distributions are generally made throughout the year, but they are taken into account on the last day of the partnership's tax year. To minimize capital gains on distributions exceeding a partner's equity, the basis is 1st increased by the amount of income earned during the year, then it is decreased by any distributions: any excess distribution over the partner's basis is taxable as a capital gain. Property DistributionsWhen property is distributed to a partner, then the partnership must treat it as a sale at fair market value (FMV). The partner's capital account is decreased by the FMV of the property distributed. The book gain or loss on the constructive sale is apportioned to each of the partners' accounts. Generally, there are no tax consequences of a current property distribution — there is never a taxable gain or loss, either to the partnership or to the partner. The partnership's inside basis of the property carries over to become the partner's basis, thereby reducing the partner's outside basis by the carryover basis. As with the cash distribution, if the FMV of the property exceeds the partner's outside basis in the partnership, then the partner's interest in the partnership is reduced to 0 and the receiving partner's basis in the distributed property equals his outside basis in the partnership before the distribution. The property basis remaining after subtracting the outside basis is taxable as a gain. Example: Tax Liability Incurred When Property Is Distributed to a Partner
If distributed property also had a secured liability, then the partner assumes the liability which decreases her share of the partnership's liabilities. The other partners' share of liabilities is also decreased by the deemed distribution. If any part of the distribution exceeds a partner's basis in the partnership, then the excess is treated as a capital gain. If a distribution consists of unrealized receivables or substantially appreciated inventory items, defined as having a FMV exceeding 120% of the partnership's adjusted basis for the property, then the exchange may be treated as a sale or other taxable exchange, unless the partner contributed the property or the distribution was a distributive share or guaranteed payment to a retiring partner or a deceased partner's successor in interest. If a partner receives an inventory item from the partnership, and the partner disposes of the item within 5 years, then he must recognize ordinary gain or loss on the property, regardless of whether it would otherwise be a capital asset. Allocating BasisWhen a partner receives a property distribution, the holding period for the property is added onto the holding period of the partnership plus the holding period of the partner who contributed the property, if applicable. So if a partner contributed property, with a holding period of 1 year, to the partnership, and the partnership held the property for 2 years, then a distribution of that property to another partner would result in a carryover holding period of 3 years to the receiving partner. If several properties are distributed to a partner, then basis must be allocated to the individual properties. Generally, the carryover basis of each property will be equal to the partnership's basis in the property, but since the total property basis cannot exceed the partner's outside basis minus any money received, then any excess basis must be allocated among the properties. Basis must 1st be allocated to unrealized receivables and inventory items. If there is any excess basis over the partnership's interest, then the assigned bases must be reduced by the excess. Any remaining allocable basis is then assigned to the remaining properties, reduced by any excess basis over the partner's remaining interest. Any basis increase should 1st be allocated to property with unrealized appreciation in proportion to that appreciation; any remaining basis should be allocated among all properties in proportion to their FMV. Example: Allocating a Basis Increase
If there is a decrease in basis, then the decrease should be allocated proportionally to the properties with unrealized depreciation; then any remaining basis decrease should be allocated to all properties in proportion to their basis. Summary of the Allocation of Basis Rules to Liquidating Distributions
Losses are only recognized in a liquidating distribution consisting of money, unrealized receivables, or inventory. In a liquidating distribution, if a partner's outside basis in the partnership exceeds the cash received plus the FMV of any property received, then the partner will recognize a loss to the extent of the excess. So if a partner's outside basis was $100,000 in a partnership, but received $60,000 in cash and $10,000 worth of inventory items, then the terminating partner would recognize a capital loss of $30,000 (= $100,000 – $60,000 – $10,000). In a liquidating distribution, the basis of property received by a partner = the basis of the partnership interest minus any money received in the same transaction, so the carryover basis in the property can never exceed the partner's outside basis in the partnership: Partner's Basis in Property in Liquidating Distribution = Partner's Outside Basis – Money Received
Partner's Basis in Property = $100,000 Outside Basis – $100,000 Cash Received A gain or loss may also be recognized by a partner who contributes property to the partnership that is subsequently distributed to another partner within 7 years, in which case, the contributing partner would recognize a gain of the FMV of the property over the partner's original tax basis in the property. The IRS introduced new forms, Schedules K-2 and K-3, for pass-through entities and filers of Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships to standardize international tax reporting of international business activities or foreign partners for tax years 2021 and thereafter. Schedule K-2 reports partners’ distributive shares or S corporation shareholders’ pro-rata shares of international items and Schedule K-3 reports their share of these items. These schedules may still be necessary even if the business entity had no foreign source income, if a partner or shareholder claims a credit for foreign taxes, though the IRS has provided some transition relief (Notice 2022-38) for good faith efforts to comply with these new provisions. References
How do you calculate partner's basis?Transactional Method. Under this method, the partner's tax basis capital account is calculated by starting with cash plus the tax basis of assets contributed, less any liabilities assumed by the partnership, plus income or loss allocated to the partner, less any distributions.
What items affect a partner's basis?The basis of a partner's interest in a partnership ( ¶443) is increased by his or her distributive share of partnership taxable income, the partnership's tax-exempt income, and the excess of partnership deductions for depletion over the basis to the partnership of the depletable property ( Code Sec. 705).
Why is partnership basis important?Maintaining basis is important because it determines how much you may withdraw or deduct from the partnership without recognizing additional gain or without being limited on the allowable pass-through of partnership losses.
How do I find my partner's outside basis?A partner's outside basis can generally be computed as the partner's capital account plus the partner's share of liabilities. Some examples of the effect on the partner's capital account and outside basis include: Contributions to partnership – Increases capital account and outside basis.
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