If you own any investment, you’ve likely heard the word basis. It can be a complicated concept, but it boils down to one simple idea, namely what your economic interest is in an investment. For example, if you purchase stock in a C Corporation for $10 and later sell that stock for $15, your basis is the original $10, which brings the recognized gain to $5. This example helps to illustrate the overall concept of basis. However, it becomes muddied with more complicated investment structures.
There are two distinct concepts of basis that apply to partnerships and their partners. First, the partnership has an adjusted basis in its assets. This basis is sometimes referred to as “inside basis.” Second, each partner has an adjusted basis in its partnership interest. This basis is sometimes referred to as “outside basis.” The amount of a partner’s adjusted basis in its partnership interest is significant in several circumstances, including the determination of the amount of gain or loss recognized by the partner upon a distribution of property by the partnership, the deductibility of partnership losses by the partner, and the determination of gain or loss on the sale or exchange of the partnership interest. The calculation of a partner’s outside basis is done by adding and subtracting certain items.
Common items that increase a partner’s outside basis are:
- Any contribution of cash, property, or services
- The increased share of partnership liabilities in the year
- Any recognition of income, including tax exempt income
Common items that decrease a partner’s outside basis are:
- Any distribution of cash or property
- The decreased share of partnership liabilities in the year
- Any recognition of losses or deductions, including nondeductible expenses
The new instructions for 2018 Form 1065 institute a new requirement for the disclosure of each partner’s tax basis capital account. The requirement applies if the partnership reports on a basis other than tax (shown on Part II Line L of the K-1) and the tax basis capital would be negative either at the beginning or ending of the current tax year. If any of these situations apply, the partnership is required to disclose the beginning and ending tax basis capital for the current reporting tax year on each partner’s Schedule K-1 under box 20, line AH. Tax basis capital is defined a little differently from above, calculated as the addition of all contributions to the partnership, less any distributions, plus all taxable and tax-exempt income, less taxable losses and nondeductible expenses. The new requirement means that many partnerships will now need to calculate the tax basis capital accounts of all the partners going back to inception, which can be a very time-consuming process for 2018.
A shareholder’s basis in an S Corporation is based on the same basic concepts as a partnership, with a caveat in the treatment of liabilities. A partnership, as described above, takes the partnership’s liabilities into account when determining outside basis. An S Corporation, on the other hand, does not consider labilities of the corporation as a part of basis. Only loans directly from a shareholder to the corporation are included in the shareholder’s basis.
The new instructions for 2018 Form 1040 Schedule E require S-Corporation shareholders to attach a tax basis calculation if any of the following events occurs: the shareholder reports a loss from the corporation, disposes of stock, or receives a loan repayment or distribution. This calculation is done on a worksheet which will take into account all of the taxable income, losses, contributions, distributions, and loans. This also will need to be calculated from inception of the S Corporation.
Basis can be complicated both in theory and in practice, but understanding the basics can be very helpful in knowing when analysis must be done, especially in the wake of new tax law. If you have any questions regarding these concepts or any other tax matters, please do not hesitate to contact your L&B professional at (858) 558-9200.