Section 705: Calculating a Partner’s Basis
A partner's basis is a dynamic measure of their tax investment, critical for determining the tax effects of distributions and the deductibility of losses.
Section 705 of the Internal Revenue Code provides the rules for calculating a partner’s adjusted basis in a partnership interest, often called “outside basis.” This figure represents a partner’s total tax investment and is tracked over the life of the partnership. It is separate from the partner’s capital account, which is an accounting measure of equity.
Maintaining an accurate outside basis ensures that partnership income is taxed only once and prevents the double deduction of losses. A partner’s basis is used to determine the taxable gain or loss on a distribution or sale of their interest and also limits the amount of partnership losses they can deduct annually.
Establishing the Initial Partner Basis
A partner’s basis calculation begins with establishing an initial, or “Day 1,” basis. The method for determining this starting figure depends on how the partnership interest was acquired.
When a partner contributes cash to the partnership, the initial basis is the amount of money contributed. For example, a $50,000 cash contribution results in an initial basis of $50,000.
If a partner contributes property, the initial basis is the same as their adjusted basis in the contributed property, a concept known as “substituted basis” under Section 722. For instance, if a partner contributes equipment with an adjusted basis of $70,000, their initial basis is $70,000, regardless of the property’s current fair market value. Concurrently, under Section 723, the partnership takes the same $70,000 basis in the asset itself, which is a “carryover basis.”
The third way to acquire a partnership interest is by purchasing it from an existing partner. In this transaction, the new partner’s basis is the purchase price. Paying $125,000 for an interest sets the new partner’s initial basis at $125,000.
Calculating Annual Adjustments to Basis
Once the initial basis is established, it must be adjusted annually to reflect the partner’s ongoing investment and the partnership’s operations. Section 705 dictates what increases or decreases a partner’s basis annually. These adjustments are calculated at the end of the partnership’s taxable year.
Items that Increase Basis
A partner’s basis is increased by their distributive share of the partnership’s income. This includes both taxable income, as determined under Section 703, and tax-exempt income. For example, if a partner with a 25% share is in a partnership that earns $100,000 in taxable income and receives $20,000 in tax-exempt municipal bond interest, their basis would increase by $30,000.
Another item that increases basis is any additional capital the partner contributes to the partnership during the year. Subsequent cash or property contributions also add to the partner’s tax investment.
Items that Decrease Basis
Conversely, several items decrease a partner’s basis, though it can never be reduced below zero. The most common decrease comes from distributions of money or property from the partnership to the partner. The basis is reduced by the amount of money and the adjusted basis of any property distributed, and distributions are taken into account before partnership losses for the year.
A partner’s basis is also decreased by their distributive share of partnership losses. Under Section 704, a partner can only deduct losses up to the amount of their adjusted basis. For example, if a partner with a $50,000 basis is allocated a $60,000 loss, they can only deduct $50,000 of that loss, which reduces their basis to zero. The remaining $10,000 loss is suspended and carried forward to future years.
Finally, basis is reduced by the partner’s share of partnership expenditures that are not deductible for tax purposes and are not properly chargeable to a capital account, such as certain fines or penalties.
The Impact of Partnership Liabilities
A partner’s basis calculation is also significantly affected by the partnership’s liabilities. Under the rules of Section 752, a partner’s share of the partnership’s debts is included in their outside basis.
An increase in a partner’s share of partnership liabilities is treated as a deemed cash contribution from the partner to the partnership, which increases the partner’s basis. For example, if a partnership takes out a $100,000 loan, and a 50% partner’s share of that liability is $50,000, their basis increases by $50,000.
Conversely, a decrease in a partner’s share of liabilities is treated as a deemed cash distribution from the partnership to the partner, which reduces the partner’s basis. If the same partnership later repays $40,000 of its loan, the 50% partner’s share of liabilities decreases by $20,000, resulting in a $20,000 basis reduction.
The allocation of these liabilities among partners depends on whether the debt is recourse or nonrecourse. Recourse liabilities are allocated to the partners who bear the economic risk of loss, while nonrecourse liabilities are allocated among all partners, often based on their profit-sharing ratios.
The Alternative Rule for Basis Determination
The Internal Revenue Code provides a relief provision in Section 705 that outlines an alternative rule for determining basis. This rule is for limited situations where the standard method is not feasible.
The alternative rule may be invoked when a partnership has existed for many years and historical records are incomplete or missing. This method is an exception, not a choice for convenience, and is reserved for situations where a precise historical reconstruction is impossible.
Under this alternative method, a partner’s basis is determined by their proportionate share of the adjusted basis of the partnership’s property as if the partnership were to terminate. The calculation starts with the partner’s share of the partnership’s basis in its assets. Adjustments are then made to account for any significant discrepancies that may have arisen from events like contributions of property with a built-in gain or loss.