Because the partnership is not viewed for tax purposes as a separate distinct entity but, rather, as consisting of separate distinct individuals, the individual partner's interest in the partnership must be measured for tax purposes. This individual interest is referred to as the partner's tax basis. The tax basis is primarily used to measure the tax gain or loss resulting from a partner's sale of his/her interest in the partnership. In the most simple of cases, the partner's tax basis is equal to cash contributed plus his/her personal tax basis in other property transferred to the partnership. This personal tax basis would represent the tax basis of the asset before transfer to the partnership.
To illustrate, assume a partner contributes $10,000 cash and equipment with a fair value of $70,000. The original cost of the equipment less depreciation taken for tax purposes resulted in a personal tax basis of $50,000. The tax and GAAP (book) basis of the partner's interest is calculated as follows:
Basis for partner's interest
Tax GAAP (Book)
Notice that the partner's tax basis in assets prior to transfer is not changed subsequent to transfer. In other words, the individual partner receives no increase (step-up) or decrease (step-down) in basis.
The calculation of a partner's tax basis becomes more complex when personal liabilities are transferred to and assumed by the partnership. A partner's tax basis is decreased by the value of the liabilities assumed by other partners. When the other partners assume a portion of the debt, it is as though that amount of debt has been forgiven. Forgiveness of debt represents income to a taxpayer. This income is eventually recognized upon the sale of a partnership interest because the tax basis has been reduced by this amount; therefore, the gain on the sale is increased by this amount. Alternatively, a partner's tax basis is increased by the value of other partners' liabilities assumed by them. The allocation among partners of liabilities transferred to a partnership is based on the partners' respective profit and loss ratios.
To illustrate, assume Partners A and B contribute assets with personal tax bases of $80,000 and $110,000, respectively. Liabilities associated with these assets are $30,000 and $60,000, respectively for A and B. Profits and losses are allocated 40% to Partner A and 60% to Partner B. The tax basis of the partners is determined as follows:
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