Question

Describe ways in which the tax basis of a partner’s ownership interest can vary from fair market value.

Answer 1

Whether earnings are retained in a partnership or distributed to partners has no affect on the taxation of those earnings, since the partners have to pay tax on the earnings whether they are distributed or not. Earnings are distributed to each partner's capital account from which distributions are charged against. However, certain types of distributions and any distributions that exceed the partner's basis may result in gains or losses that must be reported for the year in which they occur.

To understand the taxation of partnerships and distributions, it is necessary to know the 2 types of tax bases concerning partnerships. The inside basis is the partnership's tax basis in the individual assets. The outside basis is the tax basis of each individual partner's interest in the partnership. When a partner contributes property to the partnership, the partnership's basis in the contributed property is equal to its fair market value (FMV). However, the outside basis of the partner increases only by the amount of the basis that the partner had in the property.

Example: Inside and Outside Basis

You contribute land to a partnership with a tax basis of $10,000 and a FMV of $50,000. Your other partner contributes $50,000 cash. Since the FMV of the land is also $50,000, you each have equal equity in the partnership, and the total inside basis of the partnership is equal to $100,000, your combined contributions. However, your outside basis differs from your partner's, since your outside basis is $10,000, while that of your partner's is $50,000. If you sold your partnership interest for $50,000, you would recognize a gain of $40,000, whereas your partner, if she sold at the same price, would recognize no gain.

There are 2 types of distributions: a current distribution decreases the partner's capital account without terminating it, whereas a liquidating distribution pays the entire capital account to the partner, thereby eliminating the partner's equity interest in the partnership. Generally, losses are only recognized in a liquidating distribution.

Cash Distributions

No gain is recognized from a distribution of cash or marketable securities that can easily be converted to cash, unless the distribution is more than the partner's outside basis, in which case, the excess is taxable as a capital gain.

Capital Gain = Cash Distribution – Partner's Outside Basis

Distributions are generally made throughout the year, but they are taken into account on the last day of the partnership's tax year. To minimize capital gains on distributions that may be greater than a partner's equity, the basis is 1^st increased by the amount of income earned during the year, then it is decreased by any distributions: any excess distribution over the partner's basis is taxable as a capital gain.

Property Distributions

When property is distributed to a partner, then the partnership must treat it as a sale at fair market value (FMV). The partner's capital account is decreased by the FMV of the property distributed. The book gain or loss on the constructive sale is apportioned to each of the partners' accounts.

Generally, there are no tax consequences of a current property distribution — there is never a taxable gain or loss, either to the partnership or to the partner. The partnership's inside basis of the property carries over to become the partner's basis, thereby reducing the partner's outside basis by the carryover basis. As with the cash distribution, if the FMV of the property exceeds the partner's outside basis in the partnership, then the partner's interest in the partnership is reduced to 0 and the receiving partner's basis in the distributed property equals his outside basis in the partnership before the distribution. The property basis that remains after subtracting the outside basis is taxable as a gain.

Example: your adjusted basis in a partnership is $14,000. You receive a distribution of $8000 cash and land with a FMV of $3000 and an adjusted basis of $2000. Since the amount of cash received is less than your interest in the partnership, there is no taxable transaction. However, your outside basis in the partnership declines to $4000 (= $14,000 – $8000 – $2000). Subsequently, you receive a distribution of land with an adjusted inside basis of $10,000. Since your outside basis in the partnership is only $4000, your adjusted basis in the land is also $4000, and you must report a gain of $6000 (= $10,000 – $4000).

If distributed property also had a secured liability, then the partner assumes the liability which decreases her share of the partnership's liabilities. The other partners' share of liabilities is also decreased by the deemed distribution. If any part of the distribution exceeds a partner's basis in the partnership, then the excess is treated as a capital gain.

If a distribution consists of unrealized receivables or substantially appreciated inventory items, defined as having a FMV exceeding 120% of the partnership's adjusted basis for the property, then the exchange may be treated as a sale or other taxable exchange, unless the partner contributed the property or the distribution was a distributive share or guaranteed payment to a retiring partner or a deceased partner's successor in interest.

If a partner receives an inventory item from the partnership, and the partner disposes of the item within 5 years, then he must recognize ordinary gain or loss on the property, regardless of whether it would otherwise be a capital asset.