Partnership

Taxation

Module 3

Liabilities and Basis

Section A... Basis Determination - In General

Selected Readings

Please browse the following statutory provisions

 

Code Sections
Regulations

705


General Theory of Partner's Basis in a Partnership

The purposes for determining a partner's basis in a partnership are threefold:

  1. A partner's basis is used to measure the gain or loss from a sale or taxable exchange of a partner's interest in the partnership or the liquidation of a partner's interest in the partnership (741 and 731),
  2. A partner's basis is used in determining the basis of partnership property (other than money) received in liquidation of the partner's interest in the partnership (732(b)), and
  3. A partner's basis is important because it is used to limit the deductibility of a partner's share of partnership losses. ( 704(d)).

"Outside" Versus "Inside" Basis -Why Is it Differenct?

Many times, a partner's basis for his or her partnership interest ("outside" basis) does not equal the partnership's basis for its assets ("inside" basis). This inequality may occur, for example, as a result of the acquisition of a partnership interest through purchase or inheritance.

If a partnership interest is acquired from an existing partner, the purchasing partner will take a cost basis in the partnership interest, which may be higher or lower than the basis of the partnership interest in the hands of the selling partner. As a result, the purchasing partner's basis in the partnership interest will differ from his (or her) share of the basis of the partnership's assets. To equalize the inside and outside bases, the partnership may elect to adjust the basis of its assets. 743(b).

Example 1

Partner P owns a one-third interest in the PQR partnership that has assets with a FMV of $30,000 and an inside basis of $24,000. Further assume that P has an outside basis of $8,000 which is equal to his share of inside basis (1/3 of $24,000). If P sells his interest to S for its value $10,000, S will now have an outside basis of $10,000 (what he paid for it) but his share of inside basis will still remain at $8,000 (1/3 of $24,000).

Note that this disparity can be remedied with a 754 election discussed later in the course.

Basis Upon Acquisition

The basis of the partnership interest received by the contributing partner equals:
  1. The amount of any cash contribution;
  2. The adjusted basis of any property contributed; plus
  3. The amount, if any, of gain recognized under 721(b).

An adjustment to the basis amount above may be required when property subject to a liability is contributed to the partnership, or when the partnership assumes a liability from any partner.

If a partnership interest is acquired other than as a result of a contribution of property (e.g., by purchase of an existing partner's interest or acquisition of a partnership interest from a decedent), the partner's basis is determined under the general basis rules of 1011, 1012, 1014, 1015, etc.


Adjustments to Basis

As a result of the operations, the basis that a partner has in his or her partnership interest will fluctuate throughout the term of the partner's ownership. The basis of a partner's interest in the partnership will either increase or decrease by the following: 705.

  1. Increases to Basis. The basis of a partnership interest is increased by:
    a. Additional contributions to the partnership or other forms of acquisition (e.g., purchases),
    b. The partner's share of partnership taxable income, tax-exempt income,
    c. Depletion deductions in excess of the basis of the property subject to depletion , and
    d. An increase in the partner's share of partnership liabilities (including partnership liabilities assumed by the partner).
  2. Decreases to Basis. A partner's basis is decreased by:
    a. Distributions of money or other property from the partnership.
    b. The partner's share of partnership losses and nondeductible, noncapitalized expenditures, including the partner's share of disallowed partnership losses if such losses reduce the basis of partnership assets without a corresponding effect on its income. Rev. Rul. 96-10, 1996-1 C.B. 138 and 705(a)(2).
    c. Any reduction in a partner's allocable share of partnership liabilities. In Rev. Rul. 94-4, 1994-1 C.B. 195, the IRS stated that a reduction in a partner's share of partnership debt is treated as an advance of cash to the partner and is taken into account at the end of the partnership year. This ruling formalized existing IRS policy that the decrease in basis occurs on the last day of the year and not on the mid-year date when the partner's share of debt declines. 752(b)
    d. The partner's deduction for depletion with respect to certain oil and gas property of the partnership (but not in excess of the partner's proportionate share of adjusted basis of such property). 705(a)(3)

Alternative Rule for Basis Determination

Section 705(b) allows the Commissioner to prescribe rules by which the adjusted basis of a partner's interest may be determined by reference to the share of the adjusted basis of partnership property which would be distributable upon the termination of the partnership. This alternative rule is available where it is not practical to apply the 705(a) general rule or where it is reasonable to conclude that the result will not vary substantially from that which would be obtained under the general rule. In practice, the IRS will often accept a taxpayer's "good faith effort" to compute basis under 705(b).


Additional Considerations

The items must be taken into account when a partner's basis in a partnership is being computed.

  • No Negative Basis: The basis of a partner's interest in a partnership cannot be reduced below zero. This situation has a potential to occur when a partner receives a distribution from the partnership or has a loss in excess of their outside basis. 705(a)(2)&(3).Thus, instead of reducing basis below zero, a partner is fully taxed on distributions of cash in excess of basis and then takes a zero basis in any noncash property distributions.
  • Tax-Exempt Income: Tax-exempt income that increases basis should include only that income which is permanently tax-exempt. Income that is tax-deferred rather than exempt (such as a nonrecognized gain on a like-kind exchange) should not trigger a basis increase. For example, in Rev. Rul. 96-10, 1996-1 C.B. 138, a sale of property between two related partnerships for which a loss was disallowed under 707(b)(1) was followed by the sale of the property to an unrelated party for which gain was not recognized under 267(d). The IRS held that the partners decreased the bases of their partnership interests for their shares of the partnership's disallowed loss and increased the bases of their interests for their shares of the gain that was not recognized.
  • Timing of Basis Adjustments: In determining a partner's basis for purposes of the limitation of 704(d), a partner's basis is first increased for his or her distributive share of partnership income items under 705(a)(1), and decreased by distributions and other items under 705(a)(2) except for losses. The partner's basis thus determined serves as the limitation on the deduction of partnership losses. Treas. Reg. 1.704-1(d)(2).

    Rev. Rul. 66-94, 1966-1 C.B. 166, illustrates the ordering rules for determining a partner's basis for partnership loss purposes. Contributions to a partnership and distributions from a partnership (including cash distributions) reduce a partner's basis before partnership losses are taken into account. c. Losses suspended on pro rata basis. If losses exceed the partner's basis, the deductible losses are deemed to consist of a pro rata share of each type of loss (e.g., ordinary and capital loss). Treas. Reg. 1.704-1(a)(2).

    Normally, in computing the partner's basis for purposes of calculating gain on a cash distribution, the partner's basis must be determined through the date of the distribution. However, advances or draws against a partner's distributive share of partnership income and reductions in a partner's share of partnership liabilities are treated as made on the last day of the year. Treas. Reg. 1.731-1(a)(1)(ii) and Rev. Rul. 94-4.

  • Charitable Contributions: A partner's share of partnership charitable contributions is not subject to the basis limitation. See Treas. Reg. 1.704-1(d)(2) and also, PLR 8753015. If a partnership makes a charitable contribution of property, the partners' bases in their partnership interests are decreased (but not below zero) by their shares of the partnership's basis in the contributed property. Rev. Rul. 96-11, 1996-1 C.B. 140.
  • Dual Interests: A partner holding both a general and limited interest in the same partnership is treated as having a single (combined) basis for both interests. Rev. Rul. 84-53, 1984-1 C.B. 159. (A similar rule applies to combine a partner's multiple interests for capital accounting purposes. Treas. Reg. 1.704-1(b)(2)(iv)(b).

Study Questions Make your selection by clicking the appropriate response letter.

1.

Which of the following will NOT increase a partner's basis in their partnership interest?
An increase in the partner's share of liabilities.

A partner's share of tax-exempt income.

A partner's share of non-deductible items.
A parter's share of a long-term capital gain.

2.

Which of the following will increase a partner's basis in their partnership interest?
A distribution of $10,000 in cash.

A partner's share of tax-exempt income.

A partner's share of tax deferred gain.
A decrease in the partner's share of liabilities.

3.

Partnership ABC makes a charitable contribution of capital gain property (FMV of $30,000; Basis of $21,000) to a qualified charitable organization. Partner A, an individual, is a one-third partner with an outside basis of $5,000. Ignoring limitations, what is partner A's potential charitable deduction for the year?
 
$0.
 
$5,000

$7,000
 
$10,000

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