Partnership Basis: What Is It & How Does It Work? 

Summary: A fundamental understanding of partnership basis and tracking is crucial to making the best business decisions. The positions taken by a member of a partnership can directly affects its owners, which can lead to unwanted tax consequences.  

Partnership taxation can be one of the most complex areas of income tax, often requiring careful navigation. At the center of the complexity lies the concept of basis, a fundamental principal that shapes how partnership tax is applied. On the surface, basis represents a partner’s investment in the partnership, however there are a significant number of intricacies which extend beyond this basic definition.  

Understanding basis is essential for members of a partnership, demanding both attention to detail and a solid grasp on underlying tax principles. 

What is Partnership Basis?  

In the simplest form, basis measures the amount of money or value used to acquire an asset. For example, if a manufacturing company purchases machinery for $100,000, its basis in that machinery is $100,000. This basis figure is crucial as it serves as the starting point for calculating the gain or loss when the asset is disposed of or sold. 

The same principle applies to partnerships. If a partner contributes $200,000 for a 20% ownership interest in a partnership, their initial basis is $200,000. However, partnership basis is not a fixed number, it evolves over time with the partnership’s activities which includes, profits and losses, contributions, distributions, and allocations of debt. Since partnership basis can have a direct impact on the taxable items of its owners, it must be carefully tracked each year.  

Why Basis Matters in a Partnership 

Basis plays a pivotal role in determining the taxability of various items, especially within partnerships. For partners or members, basis can not only dictate the amount that can be withdrawn from the partnership, but it also shapes the allocation of income or loss to each owner and can trigger recognizable gains with unwanted tax consequences. While the concept of basis is straightforward, the rules governing the calculation and tax treatment can become highly complex when particular scenarios arise, such as: 

• Addition of new partners
• Death or exit of existing partners  
• Allocation of debt  
• The contribution of appreciated property  

Types of Partnership Basis: Inside vs. Outside 

When discussing partnership taxation, you’ll often hear the terms “inside basis” and “outside basis.” But what do they mean and what is the difference?  

• Inside basis refers to the basis of the assets “inside” or held by the partnership. 
• Outside basis is each individual partner’s basis in their own partnership interest, essentially what each partner invested into the partnership.  

The distinction between inside versus outside basis is important as complications can arise when property, in lieu of cash, is contributed or distributed. This can result in disparities between a partner’s basis and the partnership’s basis in the asset. That’s because the asset already has its own basis, fair market value, and character, which may differ once it is contributed to the partnership. For example, an asset that was deemed as an investment in the hands of the partner, could be treated as a trade or business asset in the hands of the partnership, all of which may lead to varying tax implications.  

Where does 704(b) book basis come into play?  

The concept of 704(b) basis or capital refers to the Internal Revenue Code’s (IRC) definition of book basis, which should not be confused with the financial reporting of accounts under the Generally Accepted Accounting Principles (GAAP). The IRS uses 704(b) book capital to track partner investments within a partnership, to help ensure allocations are consistent with the flow of the economics.  

Capital vs. Profits Interest  

Basis is closely tied to the type of interest an owner holds in the partnership, either capital or profits. If a partnership were to liquidate its assets, a partner with a capital interest is entitled to a share of the partnership’s assets. This is reflected in the capital account and is typically the case for a partner who has contributed appreciated property into the partnership.  

In contrast, a partner with a profits interest would not be entitled to any share of the assets but rather the profits and appreciation. In general, receiving a profits interest in exchange for services is not a taxable event, whereas receiving a capital interest may be a taxable event.  

Additional Complexities in Partnership Basis 

Like any other business, partnerships can leverage their operations by obtaining financing to cover capital expenditures or expenses. However, acquiring debt has its own impact on the basis of partners and can take varying forms:  

• Debt is classified into different categories: recourse or non-recourse  
• A partner lending money to the partnership and vice versa   
• Contributions of appreciated property with a mortgage   

The contribution of property other than cash may generate a built-in gain or loss, directly impacting a partner’s basis. In addition, the structure of the entity can also determine the treatment of debt.  

These varying factors can all adjust a partner’s basis, creating a domino effect on taxability, which then dictates how much loss a partner can recognize, what their distributions might be, or the amount of capital gain they might have to report in any given tax year. Losses have their own set of guidelines and specific ordering rules, which adds another layer of complexity.  

Final Thoughts: The Impacts of Basis 

It’s critical for businesses structured as partnerships or LLCs to maintain a fundamental understanding of how basis can impact its owners. Major events, such as capital expenditures, debt acquisition, or the transfer of a partnership interest may require in-depth analysis. Engaging a tax professional with specialized knowledge of partnership basis can help you make the proper business decisions to benefit your organization and its owners.