The analysis of inside basis vs outside basis affects the taxation of 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, operation of a business and divides its assets according to the contribution.
Section 705 of the US Internal Revenue Code provides a set of rules that govern the tax allotted for a partner; this 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 in ascertaining the partner’s distributive share of losses.
At the very core the essential concept of partnership taxation is fact that profits and loss flow through each partner present in the business and are responsible for these accounts. This means that 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 pre-requisite for any business entity that is operated by partners.
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 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.
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 by the following (IRC §705):