How Partnership Equity Is Calculated and Taxed
A partner's equity involves two distinct calculations: their economic stake and their tax position. Learn how these values are determined and how they govern tax liability.
Partnership equity represents a partner’s ownership stake in a business. Unlike corporate stock, which involves standardized shares, partnership equity is a more fluid measure of a partner’s claim on the company’s net assets. This ownership interest dictates how profits, losses, and control are divided among the partners, and its value changes with the financial performance of the business.
The Partner’s Capital Account
A partner’s capital account is the accounting record tracking their ownership stake. The account is established with an initial contribution of cash or other assets and serves as an internal measure of a partner’s economic interest, separate from tax calculations. When a partner contributes property instead of cash, the transaction is not immediately taxable to either the partner or the partnership under Internal Revenue Code Section 721. The property is recorded in the partner’s capital account at its fair market value at the time of contribution.
The balance in a partner’s capital account is regularly updated to reflect ongoing partnership activities. It increases with any additional capital contributions made by the partner and their allocated share of the partnership’s profits. The account balance is decreased by any distributions the partner takes from the business and by their allocated share of any partnership losses. The partnership agreement dictates the specific accounting method used and how profits and losses are allocated.
Acquiring Equity for Services
A person can become a partner by contributing services instead of cash or property, which has tax implications. The two forms of equity granted for services are a capital interest and a profits interest. A capital interest gives the service partner a share of the partnership’s existing capital, meaning the partner would receive a distribution if the partnership were to liquidate immediately.
Receiving a capital interest for services is a taxable event. The fair market value of the interest is treated as compensation and is taxed as ordinary income to the new partner in the year of receipt. The partnership gets a corresponding tax deduction for the same amount.
A profits interest entitles the partner to a share of the partnership’s future profits and losses, not its current assets. If the partnership were to liquidate immediately after a profits interest is granted, the partner would receive nothing. Under safe harbor provisions like Revenue Procedure 93-27, the receipt of a profits interest for services is not a taxable event. This tax treatment is contingent on the partner not disposing of the interest within two years of receipt and the interest not relating to a predictable stream of income.
Calculating Partnership Tax Basis
A partner’s tax basis, or “outside basis,” is a calculation used exclusively for tax purposes and is separate from their capital account. It determines the tax consequences of distributions and limits the amount of partnership losses a partner can deduct. A partner’s tax basis can never be below zero.
The calculation of a partner’s tax basis begins with their initial contribution, including the amount of cash contributed and the adjusted basis of any property contributed. A partner’s basis is increased by their share of the partnership’s taxable income and gains. It is also increased by their share of any partnership liabilities under Internal Revenue Code Section 752, which allows partners to receive tax-free distributions or deduct losses that might otherwise be suspended.
Conversely, a partner’s tax basis is decreased by distributions of cash or property from the partnership and by their share of partnership losses and deductions. The basis calculation is a cumulative running total that reflects the partner’s after-tax investment in the partnership at any given point in time.
Tax Consequences of Distributions
The tax treatment of a distribution depends on the nature of the asset being distributed, whether it is cash or property. When a partner receives a cash distribution, it is treated as a tax-free return of their investment up to the amount of their outside basis. The partner’s basis is reduced by the cash received, and any amount that exceeds their basis is treated as a taxable capital gain.
For distributions of property other than cash, taxation is deferred. A partner does not recognize a gain or loss upon receiving a property distribution. The partner takes the property with a “carryover basis,” meaning the partnership’s basis in the property transfers to them. However, the basis of the distributed property in the partner’s hands cannot exceed their outside basis in the partnership interest, which is then reduced by the basis of the property they receive. This system ensures the built-in gain or loss is preserved and will be recognized by the partner upon a future sale of the property.