Article on Partnership Inside & Outside Basis

Recently an issue came about regarding IRC Section 754 and it’s application to partnership matters.  The article below has been drafted by a Denver tax attorney at The McGuire Law Firm to initially discuss inside and outside basis, which will help to understand IRC Section 754.

When you hear the term “outside basis” in reference to a partnership, this refers to the basis the partnership has in the partnership assets, and how the basis of an asset is stated in partner’s capital account.  An example may be useful:  Assume John, Jimmy, Jeff and Terry form JJJT LLC and each will contribute $250,000 to JJJT LLC, which is taxed as a partnership.  After this capital infusion, the partnership will purchase land that has a value of $800,000 and other partnership assets with a value of $200,000.  Thus, when looking at the balance sheet for the partnership you would see land with a basis of $800,000 and other depreciable assets with a value of $200,000.  Further, the basis of each partner would be $250,000 with a total equity of $1,000,000.  Thus, each partner’s capital account is equal to the amount of money they contributed to the LLC, and the total of these capital accounts equals the total basis the LLC (partnership) has in the assets.  Thus, the inside basis of the partnership assets is $1 Million and each partner has a share of the inside basis of $250,000.  Thus, so far, everything is adding up and makes sense!

When you hear the term “outside basis” someone is referring to the basis a partners holds in their partnership interest.  Thus, using the example above, when the partner’s in JJJT LLC contributed $250,000 to the LLC, they will each take an initial basis in the partnership interest of $250,000, which is controlled by IRC Section 721 an states that a partner’s initial tax basis will be equal to the amount of cash and the adjusted tax basis of any property the partner contributes to the partnership.

So when and how does a problem come about?  From our example above, each partner has an outside basis equal to their share of the basis of the partnership assets, which is the inside basis of $250,000, but what happens when this changes?

Based upon the above example, we will assume that value of the land increases by 50% to $120,000 and thus the balance sheet would show that the land has a basis of $800,000 but a fair market value of $120,000 and the other assets have a basis of $200,000 and a fair market value of $200,000 and a total fair market value of $140,000.  Each partner would have a basis of $250,000 in their partnership interest and the each interest would hold a fair market value of $350,000.

Now to shake up the pot, Terry decides the value of the land has topped out and thus wants to sell his partnership interest.  Thus, Terry wishes to sell his partnership interest to Woody.  Terry’s value in his partnership interest is $350,000 and thus Woody will have to pay $350,000 for Terry’s interest.  When Terry sells his partnership interest gain will be recognized under IRC 741 of $100,000.  When Woody acquires the interest for $350,000 his initial basis is not controlled by IRC 721, but IRC 1012, which would hold that when a partner acquires the interest through a purchase, the initial basis would generally be the cost and thus $350,000 based upon the above facts.

What we now have is a difference between inside and outside basis.  Woody will have an outside basis in his partnership interest of $350,000, but nothing has changed regarding the inside basis.  Woody’s share of the inside basis would be $250,000 as Woody steps into Terry’s “smelly” shoes so to speak.  Thus, Woody’s capital account is different than his tax basis.  Woody would have a tax basis of $350,000 but a capital account of $250,000.  This difference can create problems that will be discussed in another article by a tax attorney.

Contact The McGuire Law Firm to discuss your tax questions with a Denver tax attorney.  Tax law can be confusing, but have a big impact on your business and business decisions.  You can discuss your issues and questions with a tax attorney and business attorney by contacting our firm.  Free consultation- 720-833-7705.