With the partnership extension deadline quickly approaching, partners have or will soon receive their 2023 Schedule K-1s (Form 1065s) from their investments. Schedule K-1s display the portion of partnership activity for the year, the partner’s tax capital, and their share of debt. While these details are important, this information is often overlooked. To help discern this information, it may be helpful to refresh your understanding of a partner’s tax basis and why it is critical in tax strategies.
Background on Basis
A partner’s tax basis in a partnership is an equation; it is the sum of a partner’s tax capital account plus the partner’s share of the partnership debt. A partner’s tax basis in the partnership interest is used to decide if tax losses can be allocated to a partner and if distributions can be made tax-free or result in taxable income.
A partner’s capital is their equity in the partnership. Essentially, it shows how much “skin in the game” a partner has in the partnership. Income and contributions increase capital, while losses and distributions decrease capital. At the end of the day, the partner’s tax capital account represents what the partner is entitled to on a tax basis if the partnership were to liquidate or if the partner exits the partnership. A partner’s share of capital based on the fair market value of the assets could be significantly different.
A partner also is allocated their portion of the partnership’s debt. Debt of a partnership is either “nonrecourse debt,” where the partner is not liable for repayment, or “recourse debt,” where the partner is personally liable for repayment if the partnership fails to pay, i.e., “on the hook.”
As noted above, tax basis is the sum of a partner’s tax capital account plus their share of debt. Partners can receive distributions to the extent of their basis tax-free.
There also is a difference between “inside basis” and “outside basis” to a partner. Inside basis is the partnership’s view of the partner’s ownership and is displayed on the Schedule K-1. Outside basis is the partner’s view of their ownership, which could differ from inside basis for a number of reasons. Outside basis is used to calculate the taxable gain or loss on sale of a partner’s interest and it is important to be tracked separately by each partner. Example one demonstrates this difference:
Example One
Partner A and B form XYZ partnership, each by contributing $100 cash for equal 50/50% ownership. There is no other income, loss, contributions, or distributions in Year One. There is no debt in XYZ partnership. The first day of Year Two, Partner B decides to sell their partnership interest to Partner C. Given the promising outlook for XYZ partnership’s business, Partner C decides to purchase Partner B’s interest for $125.
The partnership views Partner B’s capital—and now Partner C’s capital—to be $100, as there has been no change in activity within the partnership itself. Partner C views their new interest to be $125, as they gave economic value of this amount to enter the partnership. If XYZ partnership were to liquidate the next day, Partner C would expect to receive the economic benefit of the full $125 that they paid.
Therefore, $100 is Partner C’s inside tax capital, while $125 is Partner C’s outside tax capital. The Schedule K-1 would show $100, while Partner C should track their outside basis of $125 in their books and records.
Key Takeaway: Partners should be tracking both their outside tax capital accounts and basis. Partners should always consider basis if contemplating a sale of their partnership interest or taking a distribution from a partnership.
GAAP, Tax, & 704(b) Basis Capital
As noted above, basis—as a noun—is capital plus debt. Basis—as an adjective—is a descriptor of different categories of capital. There are three "bases"--GAAP basis (including variations of GAAP, hereby to be referred to as GAAP basis in this article). GAAP basis is the partner’s share of GAAP equity in accordance with accounting board requirements. Although rarely tracked, if a partner were to take the audited financial statements and multiply it by their ownership percentage, they would then arrive at their GAAP basis capital account.
Instead of GAAP principles, tax capital is guided by tax principles. The difference between GAAP and tax rules can cause “cumulative” timing differences. GAAP capital plus these cumulative timing differences equals tax basis capital. Example two demonstrates this concept:
Example Two
In Year Two, XYZ partnership buys a machine. GAAP rules allow $10 of depreciation, while tax rules allow $30 of depreciation. This $20 would be the difference in GAAP and tax capital, allocated between the partners according to the partnership agreement.
As a result, if a partner were to begin with their GAAP capital and add any cumulative timing differences between GAAP and tax, they would then arrive at their tax basis capital. In this example, tax basis capital would be $20 less than GAAP basis capital.
Section 704(b) basis tracks the economics of the deal. Therefore, among others, the following two situations are often common triggers for a departure of §704(b) basis from tax basis1:
- A partner contributes property (non-cash) with a fair market value different from its tax basis.
- A partner contributes cash to an existing partnership where the inside fair market value of the assets does not equal inside tax basis.
Here’s a look at each situation:
- A partner contributes property with a fair market value different from its tax basis
To form a partnership (or just to enter a partnership), partners make a contribution to “buy in” to the business. While this contribution is often cash, partners also can contribute property into the business in exchange for their ownership share.
However, the tax basis of the property will frequently be different than the fair market value of the property at the date of contribution. From the partner’s perspective, the partner should receive “economic value” for the full fair market value of the property contributed. If the partner did not, it would make more sense to simply sell the property to a third party and then contribute the proceeds of the sale instead. From a partnership perspective, however, the partnership “steps into the shoes” of the tax basis of the property in the hands of the partner. Whatever the tax basis was in the hands of the contributor becomes the tax basis in the hands of the partnership.
The difference between this “economic value” (or §704(b) basis) and “tax value” (or tax basis) is called a §704(c) built-in gain or loss (BIG/BIL). While the details are outside the scope of this article, the “method” the partnership selects to handle this §704(c) BIG/BIL could affect the allocation of income between partners year to year.
Example Three
Partner A and Partner B form Partnership AB in which they are equal owners. Partner A contributed $500 of cash, while Partner B contributes a computer worth $500. Partner B has owned the computer for a while, and it was bought three years ago for $1,000. Partner B has since claimed $700 of depreciation deductions on the computer, giving it a net tax basis of $300.
The following are the results of this situation:
| Tax Basis | 704(b) Basis | 704(c) Built-In Gain or Loss | |
|---|---|---|---|
| Partner A | $500 | $500 | $0 |
| Partner B | $300 | $500 | $200 |
You will note that even though their tax basis differs, it is suitable for them to remain 50/50 partners given that their economic §704(b) bases align. The $200 §704(c) built-in gain will reduce over time and will affect how income and loss is allocated between Partner A and Partner B.
Key Takeaway: Partnership agreements will normally specify which of three methods the partnership will use for 704(c) built-in gains or losses. The three methods are traditional, traditional with curative, and remedial. Some methods are more favorable to the partner contributing the BIG/BIL property, while others are more favorable to the “noncontributing” partners. Prior to making a contribution, discuss your options with tax advisor professionals at Forvis Mazars.
- A partner contributes cash to an existing partnership where the inside fair market value of the assets does not equal the inside tax basis.
If a partner contributes into a position in exchange for a certain percentage ownership, the fair market value of the full partnership can be deduced. In this situation, the contributing partner’s §704(b) capital account and tax capital account will be equal. However, if the fair market value of partnership assets is different from their tax basis, the noncontributing partners’ §704(b) capital account will be disproportionately different from the contributing partner’s §704(b) capital account.
Under the capital account rules of §704(b), if agreed upon in the partnership agreement, the partnership may adjust the §704(b) capital accounts to reflect the fair market value of the partnership assets2. See Example Four for an illustration:
Example Four
Prior to Partner C Entrance:
| Tax Basis | 704(b) Basis | 704(c) Built-In Gain or Loss | Ownership Per Agreement | |
|---|---|---|---|---|
| Partner A | $200 | $200 | $0 | 50% |
| Partner B | $200 | $200 | $0 | 50% |
Prior to Revaluation:
| Tax Basis | 704(b) Basis | 704(c) Built-In Gain or Loss | Ownership Per Agreement | |
|---|---|---|---|---|
| Partner A | $200 | $200 | $0 | 45% |
| Partner B | $200 | $200 | $0 | 45% |
| Partner C | $100 | $100 | $0 | 10% |
Revaluation Calculation:
If Partner C is receiving a 10% share of the entity for $100, then you can deduce that the fair market value of the entire entity is: $100/10% = $1,000. If Partner A and Partner B should both receive economic value of 45% of that $1,000, their respective §704(b) basis should be $1,000 x 45% = $450.
Following Revaluation:
| Tax Basis | 704(b) Basis | 704(c) Built-In Gain or Loss | Ownership Per Agreement | |
|---|---|---|---|---|
| Partner A | $200 | $450 | $250 | 45% |
| Partner B | $200 | $450 | $250 | 45% |
| Partner C | $100 | $100 | $0 | 10% |
As shown in this chart, the §704(b) basis now matches the intended economics of the deal as outlined in the partnership agreement. The §704(c) built-in gain would affect the allocation of income and loss in future years.
Key Takeaway: Revaluations are optional unless required in the partnership agreement. While they help to correct the economic situation of the partnership, they also require time and tracking from a compliance standpoint. Before accepting new partners into the partnership, partners should make sure they are comfortable with the proposed contribution and its resulting consequences.
Why You Should Care
Allocations
Many partners received a Schedule K-1 and wondered why the income reported does not align with the ownership percentage shown on the Schedule K-1. In short: even if they are a 50% partner, it is possible to get more or less than 50% of the partnership’s income or loss for the year. This could be due to “special allocations” agreed to within the partnership agreement. Note that for special allocations to be respected by the IRS, the allocations need to satisfy certain tests.
Depending on the presence of §704(c) BIGs or BILs (and the related methods), depreciation and amortization deductions (among other things) can be specially allocated. It is possible that some partners could have an overall loss for the year while other partners have overall income. Therefore, capital accounts and the related consequences could play a factor into annual income (loss) allocations for the year. So, as not to be caught off guard with unexpected outcomes, taxpayers also should consider these “special allocations” when making their quarterly estimated tax payments.
Distributions in Excess of Basis
As mentioned previously, partners can take distributions to the extent of their tax basis without tax consequences. Note that this rule mentions basis, and not capital. Considering the partner is allocated their share of debt, they are given “credit” for that debt by allowing for distributions to the extent of basis. Cash distributions in excess of basis result in the taxpayer having income on the excess amount. While distributions are helpful for partners in need of cash or to cover a tax bill, partners should be wary of their basis and whether they have enough basis to support the considered distribution amount.
Effects at Sale
Upon sale, whether it be the liquidation of the partnership or the sale of a partnership interest, tax capital and basis play a key role in the resulting tax effects of the transaction. For partners selling their interest to a third party, the gain they incur is based off of their outside basis in the partnership. Different “characters” of income apply based on the asset makeup of the partnership. Therefore, partners should be aware of footnotes in their Schedule K-1s that distinguish between gains attributable to ordinary income (attributable to §751 property), capital gain, etc.
Under §743(b), new partners purchasing an interest from an exiting partner could have the option to receive a basis adjustment (“step up” or “step down”) for the difference in their tax outside basis and their tax basis inside the partnership. To obtain this “step up,” however, the partnership would need to make an election (called “the §754 election”). Speak with a professional at Forvis Mazars about the options with this election and how it may help you and your partners.
At-Risk Basis
To further complicate matters, even if partners have basis to take a loss on their Schedule K-1, they may not be able to take advantage of that loss on their Form 1040. At its core, at-risk basis shows what a partner would be truly liable for in the event of default or liquidation. Therefore, at-risk basis is calculated by adding the partner’s ending tax capital to the allocated recourse and qualified nonrecourse debt of the partner. Note that this calculation should be done on an activity-by-activity basis, so beware if one Schedule K-1 includes multiple activities (which should be evident in the footnotes or statements of the Schedule K-1). It is possible that a portion of the Schedule K-1’s loss is allowed while another is not.
There is no doubt that capital accounts, basis, and debt can become complicated in partnerships. However, understanding these concepts and key planning points could help taxpayers avoid unexpected tax consequences. Reach out to a professional at Forvis Mazars advisor if you have questions about Schedule K-1s you have received or if you would like to consider options for your partnership business.