What Is a Deemed Contribution in a Partnership?

In partnership taxation, a “deemed contribution” occurs when a partner is treated as having contributed cash to the partnership, even though no money is exchanged. This is a constructive event created by tax law to ensure a partner’s tax basis accurately reflects their total investment and economic risk. Understanding this concept is important because routine partnership activities can have direct tax consequences for individual partners.

The Link Between Partnership Debt and Contributions

The most common event triggering a deemed contribution is a change in a partnership’s liabilities. When a partnership takes on debt, the Internal Revenue Code treats each partner as having contributed cash equivalent to their share of that new liability. This is because taking on a share of the partnership’s debt increases each partner’s personal economic risk in the venture.

Although the partner has not put more of their own money into the partnership, they have become responsible for a portion of its obligations. The tax code views this increased responsibility as an investment, recognizing that the assumption of debt is economically similar to a direct cash contribution.

This principle also applies when a partner’s share of existing partnership debt increases. This can happen if one partner is relieved of their share of a liability, which is then absorbed by the remaining partners. The partners who see their share of the debt go up are treated as making a deemed cash contribution.

Determining Your Share of Partnership Liabilities

Calculating a partner’s share of liabilities depends on the type of debt the partnership holds. Liabilities are categorized as either recourse or nonrecourse, and this distinction determines how the deemed contribution is allocated among the partners.

A recourse liability is a debt for which a partner is personally liable. To allocate this debt, tax regulations use an “economic risk of loss” analysis. This analysis determines the portion of the debt a partner would be obligated to pay out-of-pocket if the partnership’s assets became worthless and it liquidated.

Nonrecourse liabilities are debts for which no partner has personal economic risk of loss; the lender’s only remedy is to seize the property securing the loan. These are allocated among partners based on their profit-sharing ratios in the partnership agreement. A partner entitled to 40% of the profits is allocated 40% of the nonrecourse debt.

For a partnership with two equal partners that borrows $100,000, the allocation is often straightforward. If the loan is a recourse debt personally guaranteed by both, each is allocated $50,000 of the liability. This results in a $50,000 deemed contribution for each partner.

Impact of Deemed Contributions on Partner Basis

The immediate consequence of a deemed contribution is an increase in the partner’s “outside basis,” which is their tax-defined investment in the partnership. A partner’s basis starts with their initial contributions and is adjusted for partnership activities like income, losses, and distributions.

When a deemed contribution occurs, the amount of the increased liability share is added to the partner’s outside basis. For instance, if a partner’s share of debt increases by $20,000, their outside basis also increases by $20,000. This adjustment is based on Section 722 of the Internal Revenue Code.

This basis increase is important because it allows a partner to deduct more partnership losses on their personal tax return. A partner cannot deduct losses that exceed their basis, so a deemed contribution can create the capacity to absorb these losses.

A higher basis also allows a partner to receive larger tax-free distributions of cash or property from the partnership. Distributions are not taxable until they exceed a partner’s outside basis, so a deemed contribution provides a larger buffer before distributions become taxable.

Transactions Resulting in Deemed Contributions

Several common business transactions can result in a deemed contribution. For instance, if a new partner contributes property subject to a liability, like a building with a mortgage, the partnership assumes that debt. The other partners then take on a share of that mortgage, resulting in a deemed cash contribution for each.

When an existing partnership borrows funds to expand, its total debt increases. If a partnership secures a loan to buy new equipment or real estate, each partner’s share of this new liability is treated as a deemed contribution. This increases their respective outside basis.

Internal shifts can also trigger a deemed contribution. If partners amend their agreement to alter profit and loss sharing ratios, it can change how existing liabilities are allocated. A partner whose profit ratio increases may be allocated a larger share of existing nonrecourse debt, leading to a deemed contribution.