The Basics of Partner Tax Basis

For many, becoming a partner in a company is a career milestone. As a part-owner of a business, your life changes in many obvious ways. One of the less obvious changes is your tax situation. 

Partnerships generally don’t pay an entity-level tax. So, as a partner, you’re responsible for paying tax for your share of the partnership’s profits. Your tax liability is largely influenced by your tax basis, a complex but important concept for you to know. 

What is a Partner’s Tax Basis? 

A partner’s tax basis is the value of the partner’s interest in the partnership. In this context, “interest” is another word for ownership. 

Partner tax basis is often referred to as outside basis. Outside basis is a partner’s basis in the partnership, while inside basis is the partnership’s interest in the partnership’s assets. 

We mostly think of partnerships and their partners when discussing inside and outside basis, but these concepts also apply to S corporations and their shareholders. Because nothing about tax is simple, S corporation and partnership basis rules differ in many ways, particularly related to the treatment of third-party loans. For this article, we’ll focus solely on partnership basis. 

Why is Partner Tax Basis Important? 

As a partner, your outside basis affects the tax treatment of certain taxable events, such as: 

• Selling your partnership interest 
• Receiving distributions of partnership property, be it cash or otherwise 
• Deducting your share of partnership losses 
• And many more 

As with many areas of tax, things can get complicated fast. Tax implications are tricky with contributions and distributions of non-cash property, such as equipment, vehicles, real estate, and even interests in other entities, including partnerships. Especially when debt is involved.  

For example, the effect on outside basis differs when a partnership debt is recourse or nonrecourse. A lender can pursue a partner’s personal assets with recourse debt, but they can’t with nonrecourse debt; this key differentiation drives how much of the debt belongs to the partner for tax purposes. 

According to the IRS, partners are responsible for keeping track of their outside basis and reporting the proper information on their tax returns. Due to the many complexities, it’s worth having a trusted tax advisor assist you in computing your basis each year. 

Components of Partner Tax Basis 

When joining a partnership, your basis is generally your adjusted basis of non-cash property plus any cash contributed to the partnership. Non-cash property contributed generally applies a “step-in-the-shoes” approach to tax basis and is therefore often a carryover amount rather than a current market value. Additionally, if you bring a loan or other debt into the partnership, your basis is reduced by the portion of debt that the other partners assume. 

Let’s say Partner Z contributes a building worth $150,000, subject to a $30,000 non-resource loan, to Partnership XYZ for a one-third interest in the partnership. Partner Z has an adjusted basis of $75,000 in the building. Based on this information, Z’s outside basis is $55,000 ($75,000 adjusted basis – $30,000 loan × ⅔ assumption of liabilities by other partners). 

From there, the partner’s tax basis increases and decreases as the business earns and loses money, takes on and pays off debt, buys and sells goods, services, and property, and distributes assets to its partners. A partnership agreement governs how income, gains, losses, debt, and other items are allocated to each partner. 

Here are some of the many levers that affect a partner’s tax basis: 

• Contributions (+) 
• Distributions (-) 
• Assumption of partnership liabilities, including those from other partners (+) 
• Relief of liabilities, including those assumed by other partners (-) 
• Income (+)  
• Losses (-) 
• Nondeductible expenses (-) 

Note that partnerships can file an election with the IRS to adjust the basis of partnership assets upon distribution or transfer of a partnership interest. The election can sometimes provide meaningful tax deductions, but because the election is irrevocable, it’s important to consider any potential downsides. Your tax professional can walk you through the pros and cons of this election and prepare the election statement to include in your partnership’s annual tax return. 

Partner Tax Basis Can’t Fall Below $0 

In general, partners don’t pay tax when withdrawing cash or property from the partnership—except when the withdrawal exceeds the partner’s basis. 

Distributions of cash or property that exceed basis are taxable because a partner’s basis can’t fall below $0. When the value of a distribution is greater than the partner’s basis, the basis is reduced to $0, and the partner recognizes taxable gain on the excess distribution. 

However, it is important to remember that allocated liabilities increase a partner’s tax basis. In effect, a partner may take distributions that are considered “debt-financed” without incurring a gain or taxable event. Losses don’t apply the same way. 

Consider Partner A, who has a $50,000 adjusted basis in Partnership ABC. If Partner A receives a $60,000 cash distribution from the partnership, her basis is reduced to $0, and she’ll recognize taxable gain of $10,000.  

Deductible Tax Losses are (In Part) Limited to Partner’s At-Risk Basis 

As discussed, your outside basis is reduced by your share of partnership losses. Let’s say Partnership AB allocates income and losses equally between Partners A and B. If the partnership sustains a $100,000 loss, each partner is allocated $50,000 of losses to report on their tax returns. 

However, as a partner, you may not always deduct your full share of partnership losses on your tax return. One of the limitations is your at-risk basis, which isn’t necessarily the same as your outside basis. While outside basis includes the effects of recourse and non-recourse debt, at-risk basis includes only the debt for which the partner is either personally liable or has put up property as collateral unrelated to the debt. 

Determining your at-risk basis requires a detailed analysis of partnership debt, so it’s best to entrust an expert partnership tax advisor with these computations. 

Partner’s Tax Basis ≠ Partner Tax Capital 

You might hear your tax professional use the term “capital account.” Despite the similarity, it’s worth noting that your tax capital account isn’t the same as your outside tax basis. What might appear to be a subtle difference can sometimes be quite significant. 

Practically, partner tax capital accounts differ from outside basis in a few key ways: 

• Partner tax capital accounts don’t increase when the partner is allocated a share of partnership debt, but outside basis does. 
• Partner tax capital accounts can dip into the negatives, but outside basis can’t. 
• Partner tax capital account balances are reported on Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., which lists the partner’s allocation of partnership items. Outside basis isn’t explicitly reported on Schedule K-1. 

Here’s another way to look at it: Partner tax capital accounts track a partner’s equity stake in the partnership. Outside basis performs a similar function, but it can be a misleading measure due to loss limitations and other rules that distort basis. 

Smith + Howard: Your Partner in Navigating Partnership Taxation 

Partnership taxation isn’t known for its simplicity. While it’s not necessary for business leaders to know the ins and outs of inside and outside basis, it’s helpful to have a working understanding of tax basis, including what causes it to change and when distributions cause taxable events. 

Serving partnerships and their partners for decades, Smith + Howard has a deep bench of tax advisors skilled in tracking basis, identifying tax planning opportunities, and making partners’ financial transition into business ownership as smooth as possible. 

Contact an advisor to learn more about our tax services for partnerships and their partners.