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Prerequisite: None
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Chapter 2 - Tax Consequences of Partnership/LLC Formation
Learning Objectives
After completing this chapter, you should be able to
• Determine the tax basis of assets transferred to a partnership or LLC at formation;
• Understand the tax consequences of a transfer of liabilities to a partnership or LLC in connection with property transfers at formation;
• Determine the required tax year for a partnership or LLC;
• Analyze the tax consequences associated with the exchange of an interest in a partnership or LLC for services.
Determination of Basis
The rules governing the determination and subsequent adjustment of a partner's basis in her partnership interest are generally straightforward. Consistent with the provision in Section 721 that no gain or loss is recognized upon a transfer of property to a partnership in exchange for an interest in the partnership, Section 722 provides that a partner takes an initial basis in her partnership interest equal to the amount of money and the basis of property contributed. Section 723 provides that the partnership takes a carryover basis in property contributed.1 Thus, initially, the partnership's aggregate basis in its assets is equal to the sum of the partners' bases in their partnership interests. The same provisions apply to limited liability companies electing to be taxed as partnerships.
Effect of Entity Operations
The results of subsequent partnership operations are reflected in each partner's basis in his or her partnership interest. Section 705 provides that a partner's basis is increased by her share of partnership income, including nontaxable income. The positive adjustment for nontaxable income is necessary to maintain its tax-exempt status; otherwise such income would later be converted to taxable income in the form of gain from disposition of the partnership interest. A partner's basis in her interest is also increased by subsequent contributions of cash and/or property to the partnership. Finally, basis is increased by the excess of percentage depletion over an asset's cost in order to preserve the deductibility of percentage depletion (because deductions cannot exceed the partner's basis in the partnership interest).
Basis is decreased by the partner's share of subsequent partnership taxable losses or deductible expenses. A partner's basis is further decreased by her share of the partnership's nondeductible expenditures, for the same reason that nontaxable income increases basis. Basis is also decreased by the amount of money, and the basis to the partner under Section 732 of any property distributed to the partner by the partnership. Finally, basis is decreased by the deduction of depletion, determined at the partner level, to the extent of the cost of the depletable property.
Thus, the basis computation maintains account of a partner's tax investment in the partnership. Basis represents the amount of a partner's potential tax loss in the event the partnership's assets become completely worthless. Additionally, it represents the tax cost of the partnership interest for purposes of determining gain upon disposition.
Effect of Liabilities
General
Because general partners are liable for partnership debts, liabilities increase the amount those partners stand to lose in the event of a partnership failure. Accordingly, partnership liabilities must be included in the partners' bases. The rules governing the adjustment of partner basis to take into account partnership liabilities are provided by Section 752.
Section 752(a) provides that increases in a partner's share of partnership liabilities, or the assumption by a partner of partnership liabilities (e.g., in connection with a distribution of property), are treated as contributions of money by the partner to the partnership. Such deemed contributions increase the partner's basis in his or her partnership interest. Similarly, Section 752(b) provides that decreases in a partner's share of partnership debt, or assumptions by the partnership of a partner's debt, are treated as distributions of money by the partnership to the partner. Deemed distributions under Section 752(b) decrease the partner's basis in his or her partnership interest.
Gain under Section 731 – Deemed Distributions
Section 752(b) poses a potentially dangerous trap for the unwary. Distributions in excess of a partner's basis in her partnership interest trigger taxable gain under Section 731(a). This gain is taxed as gain from the sale of the partnership interest. Since Section 752(b) treats a decrease in a partner's share of partnership debts as a distribution of cash, an unexpected gain under Section 731(a) may often arise as a result of a partnership's payment of its debts, or as the result of a change in the partners' liability sharing ratios.
1 An exception to these rules provides that, where the partnership would be treated as an investment corporation were it incorporated, §721 does not apply. Consequently, the contributing partner does recognize gain and takes a FMV basis in her interest. The partnership's basis in its assets is increased by any such gain recognized by the partner.
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