Many times, when clients come to us to create a business, they want to do so with the least amount of effort. At this stage, they want to simply get the business up and running. And on the attorney’s side, many times, we are too focused on the limited liability consequences of entity structure, how the profits will be distributed, or the check and balances each partner holds over one another. As such, one aspect of a partnership agreement that sometimes gets overlooked: how capital contributions affect a partner’s tax basis.
What is Tax Basis? Generally, basis represents the amount an owner is considered to have invested in their property. Typically, an asset’s basis is its cost to you—the price you paid in cash, debt obligations, and other property or services. In the context of partnerships, there are two key types of basis to consider: outside basis and inside basis.
Outside Basis When a partner contributes property to a partnership, her basis in the partnership interest is equal to the sum of the adjusted basis that she had in the property she contributed (plus any cash she contributed). This is known as outside basis. In other words, outside basis is a partner’s interest in a partnership. This is based on the concept that the contributing partner has simply converted the form of her investment into partnership interest. And as such, she should be allowed to tack on the holding period she had in that property to the holding period of her partnership interest.
Inside Basis In contrast, the partnership’s basis in the contributed property is referred to as inside basis. With inside basis, the partnership receives a transferred basis in contributed property that is the same as that of the contributing property. And the partnership itself is allowed to tack on the partners’ holding period to its own.
Significance of Tax Basis Tax basis in a partnership is significant. A partner’s basis in a partnership will determine if certain transactions between a partner and the partnership will be considered a taxable event or if a partner is allowed to take a deduction. Even more, the partnership can make distributions to partners tax free until the partners have exhausted their basis in the partnership. A partnership’s debt can also create basis for partners, allowing the partnership to issue additional tax-free distributions. If the partnership takes a loss, then a partner is limited in the losses she can take based on their basis. Any losses that exceed a partner’s basis are carried forward to future years’ positive basis or income. As such, in instances, where one partner is contributing property while the other partner is contributing services, it can make sense for the allocation and distribution waterfall to state that the property contributing partner with a positive basis is allowed to take the partnership losses before the other service partner. Partners often do not think of basis and the tax ramifications of launching a partnership. Managing your basis is essential when operating a partnership. It should be a straightforward process if done year to year. Don’t ignore it, allowing it to become a headache. Make sure your counsel is advising you of the tax implications of launching your venture and that you have competent tax counsel when making contribution
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