ELITE ADVISOR BEST PRACTICES
The ABC’s of Partnership Taxation - Part Two
When your clients purchase or inherit a partnership interest: special focus on outside basis
By Janice Eiseman
- It is necessary to understand that a partnership interest purchased or acquired by your client has two tax bases associated with it: (1) your client’s outside basis in the partnership interest, and (2) your client’s share of the inside basis of partnership assets.
- If your client has inherited the partnership interest, the income tax basis of the interest is its fair market value at the date of death of the deceased partner (or at the alternate valuation date) plus your client’s share of the partnership liabilities.
- Entities taxed as partnerships offer the unique ability to have the basis of partnership assets adjusted for a partner who has acquired his or her interest by purchase or inheritance.
In Part One of this article I provided a broad overview of the tax principles governing the federal income taxation of entities that are taxed as partnerships, e.g., limited partnerships and limited liability companies. Because limited partnerships and limited liability companies are often the entities of choice today, it is important to understand the tax principles of these entities in greater detail. Here I will focus on what happens to your clients when they purchase or inherit a partnership interest.
Fundamental facts about partnership tax basis of a partner: the partner’s outside basis
The initial income tax basis of a partner in the partnership interest is the tax basis of the property that’s contributed to the partnership by the partner (or the amount of cash contributed by the partner to the partnership) plus the share of partnership liabilities that are allocated to the partner. Then any income and gain allocated to a partner increases the partner’s tax basis; a loss allocated to a partner decreases the partner’s tax basis; and various other adjustments to the basis may be required depending on the circumstances. “Various other adjustments” means that items such as tax exempt income must be added to the basis even though it is not part of taxable income.
When your client purchases a partnership interest, the income tax basis of the purchased partnership interest is the price that your client paid for the interest plus your client’s share of the partnership liabilities.
If your client has inherited the partnership interest, the income tax basis of the interest is its fair market value at the date of death of the partner from whom the client inherited his or her investment (or at the alternate valuation date) plus your client’s share of the partnership liabilities. The tax basis of a partner in the partnership interest is known as the partner’s “outside basis.” A partner cannot deduct losses in excess of the partner’s outside basis; hence, the ability to include liabilities in the outside basis increases the amount of losses potentially deductible by a partner. In the corporate world, by contrast, the liabilities of the corporation are not included in a shareholder’s tax basis; thus, a shareholder of an S corporation cannot increase the shareholder’s tax basis in S corporation stock by including the S corporation’s liabilities. The benefit of including liabilities in a partner’s income tax basis, however, also requires the partner’s share of liabilities to be included in the amount realized from the sale of a partnership interest.
How outside basis works
To illustrate the rule on outside basis, assume that your client has inherited a partnership interest in an old tax shelter partnership, where the tax basis of its assets is less than the amount of partnership liabilities. In other words, the partners have negative capital accounts. At the date of death of the deceased partner, the total fair market value of the partnership assets was still less than its liabilities, which means that the inherited partnership interest was worth zero. Because the date-of-death value of the partnership interest is zero, your client’s outside basis equals his or her share of the partnership liabilities under the partnership tax basis rules. If your client immediately disposes of the inherited partnership interest, your client will not recognize a gain because the amount realized and the tax basis are equal, i.e., the amount realized will equal your client’s share of the partnership liabilities, and the client’s tax basis equals the client’s share of the partnership liabilities. The income tax results would have been very different for the deceased partner if the partner had sold the partnership interest prior to the partner’s date of death. Prior to the date of death, the tax basis of the deceased partner was not equal to the deceased partner’s share of partnership liabilities.
The tax basis of the deceased partner prior to the date of death would have been equal to his or her share of the liabilities less the amount in his or her negative capital account. Consequently, the sale of the interest would have produced a gain equal to the negative capital account, i.e., the amount realized would have equaled the partner’s share of liabilities. And the tax basis would have equaled the share of liabilities less the negative capital account, resulting in a gain equal to the negative capital account. The partner would have had “phantom income,” i.e., the partner would have received no cash equal to the amount of gain. Perhaps you have heard the saying that “the only way to avoid phantom income from a negative capital account is to die!”
It is important that you have an overview of the partnership tax basis rules so you can advise your clients properly and confidently about them. By understanding the tax basis rules, you can talk to your client about “phantom gain.” In the next installment we’ll focus on the concept of the inside basis.