US Partnership Tax: Partner's Basis and Liabilities

Basis is one of the most important concepts in tax, as it is used to determine gain or loss from the sale of an asset (see generally sections 1001-1016).  The partnership tax rules are no different.  When a partner contributes property to a partnership, the basis of the contributed property becomes the partner’s basis in his partnership interest:

The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721 (b) to the contributing partner at such time.

Like other business formation sections of the code, the creation of the new business entity leads to deferred recognition of gain from the contributed property, largely to encourage the formation of new businesses.  So, assume a partner has a basis of $100 in contributed property.  That basis could carry over to his partnership interest.
Lets’ add another wrinkle to the discussion and discuss the effect of liabilities on the partner’s basis.   The partnership tax code distinguishes between recourse and non-recourse liabilities.  “A liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability under section 1.752-2. (Treas. Reg. 1.752-1(a)(1)).  Section 752 of the Treasury Regulations uses a method called a “constructive liquidation” to determine a partner’s responsibility for a liability.  In this calculation the following events happen:

(i) All of the partnership's liabilities become payable in full;

(ii) With the exception of property contributed to secure a partnership liability (see § 1.752-2(h)(2)), all of the partnership's assets, including cash, have a value of zero;

(iii) The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditors's right to repayment is limited solely to one or more assets of the partnership);

(iv) All items of income, gain, loss, or deduction are allocated among the partners; and

(v) The partnership liquidates

Basically, the calculations assume the worst possible economic situation happens: namely, that the partnership suddenly has absolutely no assets and the partners are on the hook for the entire amount of the liabilities.   To fast forward to the end, “In this context, “economic risk of loss” is a proxy for loss allocations. (Taxation of Partnerships and Partners, Mckee, Nelson and Whitmire, ©2008 RIA, 8.03(1)).  


In contrast to recourse liabilities are non-recourse liabilities which are liabilities that are “nonrecourse to the extent that no partner or related person bears the economic risk of loss for that liability under 1.752-2. (Treas. Reg. 1.752-1(a)(2)).  Before explaining these rules, a bit of history is in order.  In the 1970s, tax shelters marketed to high net worth individuals commonly used limited partnership that were loaded up with non-recourse liabilities (and a minimal initial contribution of cash), which were in turn, usually structured in such a way that the partnership never really paid on them.  For example, a partnership would require a cash contribution of $10,000 from a limited partner while taking out a $1 million dollar non-recourse loan that was essentially structured with a massive balloon payment that would occur far after the useful life of the partnership was over.  The reason for this was to inflate the partner’s basis, thereby allowing him to take a large amount of deductions for minimal capital input.  Therefore, the non-recourse allocations were changed “so as to reflect the manner in which partners share partnership profits. (Taxation of Partnerships and Partners, as above)”

Again, please remember this is a general introduction to partnership tax; there are numerous nuances to this section of the tax code that are far beyond the points listed above.  Should you have any questions, please call us at 832.330.4101.  And, as always, this is not any specific legal advice for anyone reading this.