The fundamental purpose of outside basis is to account for a partner's after-tax investment in the partnership. Outside basis determines how much a partner may withdraw or deduct from a partnership for tax purposes without recognizing additional gain or without being limited on the allowable flowthrough of partnership losses. Because of the flowthrough, single-level taxation scheme of Subchapter K where partners, not the partnership, are taxed on partnership-level transactions, a method is needed to account for each individual partner's (1) contributions and distributions; (2) allocation of profits and losses; and (3) acquisition cost for his or her partnership interest (other than by contribution). The basis calculation rules keep track of the partner's basis (i.e., his or her cost basis or after-tax investment in the partnership). The calculated basis determines the tax impact of certain transactions (e.g., if a partner receives a distribution in excess of his or her accumulated investment in the partnership).Reducing a partner's basis in partnership interest
A partner can use only two methods to withdraw money or property from a partnership: (1) a distribution or (2) a sale or other disposition of the partner's interest. (This excludes borrowing, which is only temporary, and compensation, which is not, per se, a partnership transaction.) The flowthrough of partnership losses is one additional event that reduces a partner's after-tax investment. These three situations are the only means by which a partner recovers part or all of his or her outside basis in the partnership interest. The function of basis is to make sure that, over the partnership's life, the partner does not withdraw more or less than his or her investment without some tax impact.
To the extent that the partner merely withdraws his or her previously taxed investment in a partnership, there is no tax impact other than a reduction of the partner's basis in the partnership interest. If a partner withdraws more than his or her previously taxed investment, whether by distribution or as a result of the disposition of his or her interest, he or she must report a gain (Secs. 731(a)(1) and 741). If, over the life of the partnership, the sum of the partner's distributions and the amount received on disposition are less than the partner's tax investment in the partnership, he or she reports a loss (Secs. 731(a)(2) and 741). If the partnership attempts to allocate the partner more loss than the remaining outside basis in his or her partnership interest, the excess losses are suspended until he or she invests additional amounts in the partnership (or reports additional partnership income) (Sec. 704(d)).
Technically, the basis limitation that causes gain to be recognized on a distribution, or that limits the partner's ability to currently recognize loss, is the rule that a partner's basis cannot be reduced below zero (Secs. 705(a)(2) and 733). So long as a partner has basis, distributions to the partner merely result in a reduction of his or her basis by the amount of money distributed or the basis of the property distributed. Allocated losses also reduce the partner's basis (Sec. 705(a)(2)(A)).
A corollary of the equality-of-inside-and-outside-basis rule is that only in rare circumstances will a partner be distributed money in excess of his or her partnership basis, but, should it happen, instead of his or her basis being reduced below zero, the partner recognizes gain. If (1) the partnership's inside basis and the partners' total outside basis are equal, (2) the outside basis of a partner represents his or her post-tax investment in the partnership, and (3) the inside basis of a partnership represents its post-tax investment in all of its assets, then the partner's outside basis also represents his or her share of the partnership's inside investment in the partnership assets. A distribution of money to a partner in excess of his or her basis means that the partner is receiving a distribution of basis that belongs to another partner, in that it is reflected in the outside basis of another partner. Frequently, this situation occurs where the distribution is also an asset transfer of some type among the partners.
Example 1: Partnership ABC holds two assets: $3,000 cash and an asset with a fair market value of $3,000 and a zero basis. (This is not a Sec. 751 hot asset.) ABC has three partners who each have a $1,000 basis in the partnership. Partner A, in liquidation of her interest, receives $2,000 cash. Economically this is appropriate because the value of her one-third interest in the partnership is $2,000. A recognizes $1,000 gain (which, in fact, represents her share of the gain potential in the partnership's assets). The partnership's new inside basis in its assets ($1,000) and the partners' outside basis ($2,000) are now out of balance. If the partnership makes an election under Sec. 754, it increases the basis of its assets to $2,000, thus restoring the balance. If the election is not made, the imbalance is permanent (and note that in this case the tax books will not balance, as the total book value of the partnership assets exceeds the total tax basis of the partners).
When the partnership finally sells the asset, the partnership will recognize a $3,000 gain so that B and C, in effect, recognize A's share of the gain in the asset. This extra gain results in B and C's recognition of a tax loss on the liquidation of the partnership (Sec. 731(a)(1)). Similarly, once a partner's basis is zero, any additional allocation of losses is suspended until the partner has basis to offset the loss (Sec. 704(d)).
The function of basis
Thus, the function of basis can be summarized as follows:
- Determines whether gain or loss is recognized (Sec. 731(a)).
- Limits the basis of distributed property (if the basis of distributed property in the hands of the partnership exceeds the basis of the distributee in his or her partnership interest) (Sec. 732).
- Loss limitations: Determines the partner's allocable share of partnership losses that can currently be used by the partner to offset nonpartnership income (subject to nonpartnership limitations) (Sec. 704(d)).
- Disposition of partnership interest: Determines the gain or loss on the sale or exchange of a partnership interest (Sec. 741).
There is one temporary exception to the rule that a partner's basis is equal to his or her cost basis in the partnership, and that is the allocation for basis purposes of partnership liabilities. The partnership's liabilities (for determining the partners' basis) are allocated to each partner under Sec. 752.
While the role of debt in the calculation of basis is important, that importance should not be overemphasized. Ultimately, the inclusion of debt in basis either has no impact at all or merely affects timing issues. Over the partnership's life, the impact of debt is zero. Each dollar of debt must be repaid by a dollar of earnings or profits (including minimum gain for nonrecourse debt) or by making contributions of capital. Ultimately, basis created by debt is replaced with basis from partnership earnings or partner contributions.Comparing partnership and S corporation basis rules
Basis affects the tax consequences of various transactions to partners and S corporation shareholders. While there are differences in the details of how basis is computed for these two types of owners, the purposes for which basis must be determined (and the reasons sufficient basis is important) are the same.
Basis can be generated by contributing cash to, or buying additional stock from, the S corporation. (Contributions to capital are typically used only where pro rata among all shareholders.) This strategy also works for partner contributions or purchases of additional units. The shareholder or partner should receive basis even when the funds are borrowed from a third party, so long as the transaction is not a sham.
A shareholder or partner can also increase basis by lending cash to the entity. If the shareholder or partner lacks the funds necessary to make the loan, a so-called back-to-back loan, in which the shareholder or partner borrows funds from a third-party lender and then relends them to the entity, can be used. If the third-party lender demands a security interest in the entity's assets, such an interest should pass first to the shareholder/partner and then to the third party. This will avoid problems with the IRS concerning the use of entity assets for the owner's personal purposes.
Practice tip: Since a loan does not create an increased ownership interest in an S corporation or partnership, an increased share of the allocation of losses will not result. Thus, although a loan will generate basis for deducting the loss, an additional investment that increases the shareholder's or partner's ownership interest relative to that of the other owners may be preferable for tax purposes because it will generate basis and increase loss allocations. The downside of making a contribution (versus a loan) is that the shareholder or partner will lose the preference in repayment that a creditor would have over an equity holder if the business becomes insolvent.
A property contribution will also increase basis to the extent of the shareholder's or partner's basis in the contributed property. Gain (if any) recognized by the contributor as a result of the transaction will yield additional basis.
The S corporation shareholder does not increase tax basis for loans made by third parties to the S corporation, even though the shareholder often is a guarantor of that debt. Partners, however, do get basis from third-party loans. This means that partners can deduct losses in excess of their investment in the partnership to the extent of the additional basis from their shares of partnership debt. This can be a big advantage if a business expects tax losses in its early years.
Practice tip: Limited partners are usually not at economic risk of loss for recourse liabilities and, thus, are usually not allocated a share of such liabilities for basis purposes. It is somewhat unusual for commercial lenders to make nonrecourse loans, so being a general partner or guaranteeing nonrecourse debt is often the only way to obtain additional basis from partnership debt. However, being a general partner may be preferable to the common S corporation situation where the shareholders must personally guarantee the corporation's debt, without obtaining any additional basis.
Example 2. Obtaining additional tax basis from partnership debt: H and J each contribute $10,000 cash to start a 50/50 equipment leasing partnership. The partnership obtains a $99,000 recourse loan and purchases equipment for $100,000. As general partners, H and J each have basis in their partnership interests of $59,500 ($10,000 from the cash contributed plus $49,500 from each partner's share of the partnership's recourse debt) for loss deduction purposes.
If the same facts apply but the business is conducted as an S corporation owned 50% each by H and J, their basis for loss deduction purposes is limited to the $10,000 they each paid for their S corporation stock. This is true even if they each have to guarantee 50% of the corporation's loan.
This case study has been adapted from PPC's Tax Planning Guide — Partnerships, 31st Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Sheila A. Owen, Twila A. Bollinger, and Larry N. Bland Jr., published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va. For more information about this column, contact firstname.lastname@example.org.