A partnership is a legal entity composed of two or more persons who join together to carry on a trade or business and who agree to split the profits or losses. Typically, partners begin by contributing money or property and labor or skills to the business. A partner can be an individual person, corporation, trust, estate, or another partnership. Like an S corporation, a partnership is a conduit or pass-through entity. The partnership business does not pay a tax on income. Rather, the business passes items of income, loss, deduction, and credit through to the partners, who report the items and calculate the tax on their individual Form 1040 returns. Nevertheless, a partnership must file an annual informational tax return (IRS Form 1065) showing the venture’s income, gain, loss, and expenses.
If you establish a partnership and transfer property to it in exchange for a partnership interest, what are the tax consequences?
As a general rule, no gain or loss is recognized by either the partnership or its partners when property including cash is contributed in exchange for an interest in a new partnership. However, the contribution of services in exchange for a partnership interest may create a taxable transaction for the partner. This could happen, for example, if an architect designs the building housing a new architectural firm and is made a partner in return for his work on the design.
Contribution of Property
Since partners generally will recognize no gain or loss when they contribute property to a partnership, they generally can make tax-free contributions of appreciated property. This general rule is subject to certain exceptions, however. For instance, if the contributed property is encumbered by liabilities that exceed the contributor’s basis in the property, the contributing partner may be required to recognize a gain. Also, there may be later consequences for a partner who contributes appreciated property, including possible recognition of gain.
Technical Note: When a partner contributes property to a partnership, allocations of income, deductions, and gain and loss must be made to the partner to reflect any difference between the property’s fair market value and its basis to the partnership. If the partnership distributes the property to another partner within seven years of its contribution, the contributing partner recognizes gain or loss on the distribution unless the contributing partner receives certain like-kind property. If contributed property has a built-in loss, the loss can only be allocated to the contributing partner and the basis in the property for other partners is limited to the fair market value of the property at the time of contribution. For more details and for information about additional exceptions, contact an accountant or tax attorney.
Contribution of Services
The contribution of services generally creates a taxable transaction for the partner. If a partnership exchanges a capital interest for the contributed services, the fair market value of the services is considered taxable income to the contributing partner. A capital interest is one that would give the holder a share of the proceeds if the partnership were liquidated. The amount is deductible as an expense to the partnership and also becomes the partner’s basis in the partnership.
If you exchange property for a partnership interest, what will be your tax basis?
Cash Contributions
If each partner contributes only cash for his or her partnership interest, then each partner will have a tax basis equal to the amount of cash he or she contributed.
Noncash Contributions
If a partner transfers anything other than money (such as real estate or vehicles) to the partnership, the calculation gets a bit more complicated. A partner’s existing tax basis in the property transferred to the partnership becomes his or her tax basis in the partnership interest received.
Original Basis Calculation
The original basis of a partnership interest is calculated in the following manner:
Cash contributed
+ Adjusted basis of property contributed
+ Any taxable income to the partner because of contributed property
+ Any liabilities the partner assumes by becoming a partner
– Any liabilities the partnership assumes from the partner
= Partner’s original basis in partnership interest
Example(s): Assume Able acquired a 30 percent interest in a partnership by contributing property with an adjusted basis of $10,000 and an outstanding debt of $6,000. The partnership assumed the debt. Able’s adjusted basis in the partnership is calculated as follows:
Adjusted basis of property: $10,000
Debt assumed by other partners ($6,000 x 70%): ($4,200)
Able’s basis in partnership interest: $5,800
It is important to note that a partner’s basis cannot go below zero.
Changes in Basis
Over time, a partner’s basis will increase or decrease frequently. In general, a partner’s basis is increased by:
• Cash and property contributed by him or her
• Any taxable gains the partner recognizes on the transfer of property to the partnership
• Separately and nonseparately stated items of partnership income, including capital gains.
• Liabilities the partner or partnership assumes
A partner’s basis is decreased by:
• Separately and nonseparately stated items of partnership loss and deduction
• Nondeductible partnership expenses
• Cash withdrawals
• Liabilities of the partner that the partnership assumes
• Adjusted basis of partnership property distributed to the partner
What basis will the partnership take in the property received?
A partnership’s basis in contributed property generally is the same as the contributing partner’s tax basis in the property.
If you have questions, contact the Business Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
