The analysis of inside basis vs. outside basis affects the taxation of a partnership. A partnership occurs when two or more parties cooperate to advance their mutual interests. This is done when each party contributes to carrying on a trade or operation of a business and divides its assets according to the contributions of each party. Section 754 of the US Internal Revenue Code provides a set of rules that govern the tax allotted for a partner.
Section 754 requires each partner to determine their adjusted basis in order to determine the exact tax liability of the partner. This determination is normally done at the end of the year and is vital to ascertaining the partner’s distributive share of profits or losses.
At the very core, the essential concept of partnership taxation is the fact that profits and loss flow through each partner present in the business, and each is responsible for these accounts. This means that the business will not be liable to pay income tax, but will still have to pay taxes according to the partnership basis which incorporates their share of profits. This is exactly why calculating each partner’s basis has become a prep course for any business entity that is operated by partners.
Always consult your professional tax advisor before making any decisions.
Inside basis refers to the adjusted basis of each partnership asset, as determined from the partnership’s tax accounts. Inside basis usually comes from partner contributions, but may also come from purchases the partnership makes with partnership funds. This determines the partner’s tax basis according to the respective individual assets contributed to the operation of the business.
Outside basis represents each partner’s basis in the partnership interest. Each partner “owns” a share of the partnership’s inside basis for all of its assets, and all partners should maintain a record of their respective outside bases.
Typically, when a partner contributes assets to a partnership, the basis carries over from the asset basis (inside basis) to the partnership interest basis (outside basis). Moreover, 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.
Whether earnings are retained in a partnership or distributed to partners has no effect 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.
754 Adjustments to Basis
As a result of operations, the basis that a partner has in his or her partnership interest will fluctuate throughout the term of the partner’s ownership. The basis of a partner’s interest in the partnership will either increase or decrease according to the following:
Increasing basis of a partnership interest
Additional contributions to the partnership or other forms of acquisition (e.g., purchases)
The partner’s share of partnership taxable income, tax-exempt income
Depletion deductions in excess of the basis of the property subject to depletion
An increase in the partner’s share of partnership liabilities (including partnership liabilities assumed by the partner).
Decreasing partner’s basis
Distributions of money or other property from the partnership
The partner’s share of partnership losses and non-deductible, non-capitalized expenditures, including the partner’s share of disallowed partnership losses if such losses reduce the basis of partnership assets without a corresponding effect on its income
Any reduction in a partner’s allocable share of partnership liabilities. The IRS stated that a reduction in a partner’s share of partnership debt is treated as an advance of cash to the partner and is taken into account at the end of the partnership year. This ruling formalized existing IRS policy that the decrease in basis occurs on the last day of the year and not on the mid-year date when the partner’s share of debt declines.
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