Partners Basis in Partnership
Mary Dupuis, EA Terry Anderson, EA, MST 1
Why do we care about the partner’s basis? • Without basis we cannot calculate: • Amount of distributive loss taken • Gain or loss when asset is distributed to partner • Gain or loss if partner sells their interest in the partnership • Transfers such as gift of partnership interest • Allocation of partnership liabilities
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Terminology • Inside Basis: this is the A/B the partnership has in the assets that are in the partnership. This may be assets donated by partners or acquired by the partnership after formation. • Outside Basis: the partner’s basis in the partnership. IRS refers to this as Interest in the partnership • Capital Account: The ‘book value’ of each partner’s share of the partnership. • Book value: In this case, it is the Fair Market Value of the assets at the time they are donated to the partnership or acquired by the partnership. Usually this amount is not adjusted after the initial value. • Recognized vs. realized gain or loss. • Realized is actual gain or loss • Recognized is the amount that needs to be reported on tax return 3
Partnership Formation • There is no gain or loss recognized • There may be a realized gain or loss. FMV minus A/B • The partner’s basis is equal to the A/B of the asset contributed at formation. • The partner’s capital account is equal to the FMV of the item contributed, usually.
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Example: FMV is greater than A/B Partner A contributes land with a FMV of $ 45,000, an Adjusted Basis of $40,000 in exchange for a 50% interest in a new partnership. Partner B contributes $45,000 in cash. A’s outside basis is calculated as follows: Adjusted basis of land: $40,000 Built-in gain of $ 5,000 stays with partner A B’s outside basis is calculated as follows: Cash contributed by B
$ 45,000
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Example: FMV is less than A/B Partner A contributes land with a FMV of $ 40,000, an Adjusted Basis of $45,000 in exchange for a 50% interest in a new partnership. Partner B contributes $40,000 in cash. A’s outside basis is calculated as follows: Adjusted basis of land: $45,000 Built-in loss of $ 5,000 stays with partner A B’s outside basis is calculated as follows: Cash contributed by B
$ 40,000
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Encumbered Property • Recourse Loan, liability less than the A/B of the contributed property • Partner contributes property subject to a liability which the partner is responsible for paying back • The partnership takes on the liability • The transaction is treated as if the partnership gave the partner cash. So the amount of debt that the partner is relieved of is equal to his/her share of the partnership and decreases his/her basis in the partnership • The basis of the other partners in the partnership is increased by their portion of the amount of debt that the partnership takes on.
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Example: Recourse Liability Partner A contributes land with a FMV of $150,000, an Adjusted Basis of $50,000, and a mortgage of $30,000 in exchange for a 50% interest in a new partnership. Partner B contributes $120,000 in cash. A’s outside basis is calculated as follows: Adjusted basis of land: Less: Portion of liability treated as a cash distribution to A (1/2 of $30,000) Equals: A’s outside basis
B’s outside basis is calculated as follows: Cash contributed by B Plus: Portion of liability allocated to B and treated as a cash contribution by B (1/2 of $15,000) Equals: B’s outside basis
$50,000 ($15,000) $35,000
$120,000
$ 15,000 $135,000 8
Encumbered Property • Recourse Loan, liability greater than the adjusted basis of the contributed property • In general this is treated the same as a when the liability is less than the A/B with one big difference. • The partner’s outside basis cannot go below zero, so the amount by which the debt relief exceeds the A/B is a gain to the partner – but this gain does NOT increase her/his basis in the partnership • The basis of the other partners in the partnership is increased by their portion of the amount of debt that the partnership takes on
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Example: Recourse liability greater than A/B of property Partner A contributes land with a FMV of $150,000, an Adjusted Basis of $10,000, and a mortgage of $30,000 in exchange for a 50% interest in a new partnership. Partner B contributes $120,000 in cash. A’s outside basis is calculated as follows: Adjusted basis of land: $10,000 Less: Portion of liability treated as a cash distribution to A (1/2 of $30,000) ($15,000) Equals: A’s outside basis $ 0 And A has a $5,000 recognized gain (does not affect outside basis) B’s outside basis is calculated as follows: Cash contributed by B Plus: Portion of liability allocated to B and treated as a cash contribution by B (1/2 of $15,000) Equals: B’s outside basis
$120,000
$ 15,000 $135,000 10
Encumbered Property • Non-recourse loan • A little more complicated. • Allocation is equal to the sum of: • Each partner’s share of partnership minimum gain (first tier) • The amount of any taxable gain that would be allocated to the partner (second tier) • The partner’s share of the excess nonrecourse liabilities (those not allocated under the first and third tier), allocated as partnership profits are allocated (third tier)
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Example: Non-recourse greater than A/B, second tier and third tier Partner A contributes land with a FMV of $75,000, an Adjusted Basis of $50,000, and a nonrecourse loan of $60,000 in exchange for a 50% interest in a new partnership. Partner B contributes $120,000 in cash. A’s outside basis is calculated as follows: Adjusted basis of land: $ 50,000 Gain due to excess liability over A/B = $10,000 Amount of liability equal to gain: ($ 10,000) (tier 2) ½ of remaining liability: ($ 25,000) (tier 3) Equals: A’s outside basis $ 22,500
B’s outside basis is calculated as follows: Cash contributed by B Plus: Portion of liability allocated to B and treated as a cash contribution by B (1/2 of $50,000) Equals: B’s outside basis
$120,000
$ 25,000 (tier 3) $122,500
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Example: Non-recourse showing first and third tier Partner A contributes has basis of $4,000 in partnership AB, for a 40% share Partner B has basis of $6,000 in partnership AB for a 60% share Partnership AB takes out a nonrecourse loan for $90,000 to buy a building worth $90,000. It took SL depreciation of $10,000 (over 9 years)
A’s outside basis is calculated as follows: Initial Basis: Minimum gain ($90,000 – 80,000 = 10,000) X 40% Excess nonrecourse ($90,000 - $10,000) X 40% Equals: A’s outside basis
B’s outside basis is calculated as follows: Initial Basis: Minimum gain ($90,000 – 80,000 = 10,000) X 60% Excess nonrecourse ($90,000 - $10,000) X 60% Equals: B’s outside basis
$ 4,000 4,000 (tier 1) $ 32,000 (tier 3) $ 40,000
$
6,000 6,000 (tier 1) $ 48,000 (tier 3) $ 60,000 13
Services in Exchange for Partnership Share • If a partner receives a partnership interest for services they are being compensated and should realize ordinary income. This is now the partner’s basis in the partnership. • Can come in two forms: • Capital Interest • Profit Interest
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Partnership Interest for Service • Capital Interest - an interest in both future earnings and in the underlying capital. If the partnership were to dissolve today then the Capital interest partner will get a portion of the underlying assets. • Profits Interest – only an interest in future profits. If the partnership were to dissolve today then the partner would only get any earnings and perhaps a portion of the gains, but no underlying assets.
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Capital Interest • Income when the partner receives the asset – think of it as a deemed sale and then a contribution • Basis equal to the value of the asset minus any amount paid for the asset • Timing of income: • Is it encumbered in any way? • No – immediate income • Yes – income when interest is transferable • Partner can choose to elect under Section 83(b) to recognize income right away
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Capital Interest • Nature of services. • Capitalize the expense? • Amortize the expense? • Immediate deduction as wages or 1099 payment?
• 83(b) election: If you get an interest in a company (capital interest with a chance of being forfeited), you pay taxes on the value when it vests – or when you actually get the money. But, if you take the 83(b) election you can pay taxes on the present value of the future benefit.
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Example: Capital interest in the partnership A, B, and C form a partnership. A and B each contribute $60,000. C contributes services for a 1/3 interest.
Capital Interest for C: Total Assets in partnership: 1/3 of those assets, C’s outside basis:
A and B: Cash contributed by each: Less: Portion of assets allocated to C A’s and B’s outside basis (each)
$120,000 $ 40,000 Wages
$ 60,000 ($ 20,000) (each) $ 40,000
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Changes in Basis • Previous example assumed that the FMV of the property had not changed. • What if it had? • What if the property had increased in value? So that the basis of the three partners is now disproportionate because the new partner had 1/3 share of current FMV and the other partners have their share of FMV at time of formation. • Is there a gain that needs to be recognized? A loss? • Do any adjustments need to be done to the other partners’ basis?
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Profits Interest • Don’t recognize any income unless:
• The partner sells their share within 2 years or • There is a recognizable stream of income
• When does the service partner recognize the income? • When does the partnership recognize the payment for services? • Same as with the capital income - what if the payment needs to be capitalized or amortized? • How does it affect the other partners’ basis? 20
Example: Profits interest for service A, B, and C form a partnership. A and B each contribute $60,000. C contributes services for a 1/3 interest. Profits Interest for C: Total Assets in partnership:
$120,000
C has zero basis in the partnership until it starts to make money.
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Property distributions • The partnership either sells the property to a non-partner or distributes it to one of the partners. • The distribution is treated as a deemed sale of the item. Gain/loss needs to be recognized by the partnership. • Capital gain/loss is a separately stated item and not part of the partnership net income or loss. • If the property was ‘sold’ at a gain, if there is a built-in gain in the contributed property then the partner who contributed the property recognizes that gain, the rest of the gain is split evenly among the partners 22
Example: Partnership AB, with A and B being equal partners. AB distributes property worth $30,000 to Partner A or sells the property to an unrelated third party. This was property that B had contributed to the partnership. It had a built-in gain of $5,000. A/B of the property is: $11,000 Distribution is a deemed sale. Gain to partnership: $19,000 Distribution
Sale
Partner B: Basis in partnership (prior to distribution or sale)
$ 50,000
$ 50,000
Built-in gain:
$ 5,000
$ 5,000
Portion of remaining gain:
$ 7,000
$ 7,000
Outside basis:
$ 62,000
$ 62,000
$ 50,000
$ 50,000
Distribution:
($ 30,000)
-
Gain on distribution:
$
Outside basis:
$ 27,000
Partner A: Basis in partnership (prior to distribution or sale)
7,000
$
7,000
$ 57,000
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Partnership Takes on a Liability • Affect on partner basis – increase by their share • Assumes that all partners are equally responsible for the loan • If one partner takes full responsibility it only increases their basis
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Partner sells partnership interest • If you have this situation then you may need to do more research. It could affect other partners’ basis
Example: Partner sells partnership Interest Sam has basis of $24,000 in ABC Partnership, this includes $10,000 of liabilities (no inventory or unrealized receivables) Sam sells his partnership interest for $29,000. Because of relief of liabilities the selling price is considered to be $39,000 Gain is $15,000 ($39,000 - $24,0000) and it would be a capital gain. Gain maintains its character as ordinary or capital gain
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Increases in Partner’s basis • The following items increase a partner’s basis in the partnership: 1. 2. 3. 4. 5. 6. 7. 8.
Adjusted basis from preceding year Cash contributed and A/B of contributed property Liabilities taken on by the partnership Recognized gain on contributions The partnership shows net income Separately stated items – capital gains, interest and dividends, etc. Tax exempt income Depletion deductions in excess of basis
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Decreases to Partner’s Basis • The following items decrease a partner’s basis in the partnership: 1. 2. 3. 4. 5. 6. 7.
Losses Liabilities of the partner that are taken on by the partnership Taking cash out of the partnership Receiving property from the partnership Separately stated items such as capital losses, Section 179 Non deductible expenses: ½ meals, fines, penalties Depletion deductions for oil and gas wells
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Backing Into Basis • Why can’t you use the capital accounts to back into the outside basis? • Capital accounts can go below zero, outside basis cannot • Capital accounts do not reflect liabilities of the partnership
• Sorry – you need all the prior returns
• Assumption – what do people do? Assume zero? Go back 3 years or whatever you can get your hands on?
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Inputting a K-1 • The most important thing is to read the attachments. • Domestic Production deduction – I always look in the footnotes for Wages. If wages are zero, you can ignore the whole thing since the credit is limited to 50% of the wages. Code T, box 13 Domestic Production Activities information. All the info is in a footnote.
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