Anyone who is in a business partnership should have a basic understanding of their capital account– an accumulation of the assets they’ve contributed and/or withdrawn, and their share of the partnership’s earnings or losses.
There are, however, limitations as to what the capital account can really do. Understanding those limitations and their tax implications is important in planning for any partnership business decision, starting with the basics of capital accounts:
Understanding Inside Basis versus Outside Basis
Partners’ capital accounts, also referred to as their inside basis represent each partner’s share of the individual assets within (or inside) a partnership. However, tax accounting for a partnership is driven by the outside basis of that interest. Outside basis is interest returned which determined by the partner’s contributions.
Cash transactions, such as the contribution or distribution of funds,, or the allocation of profits and losses, impact inside and outside basis in the same way. But if you contributed a building to the partnership (instead of cash) inside basis would be increased by the fair market value of that building, while outside basis would only increase by your tax responsibilities for that building.
As an example, let’s say you and a partner each put $100,000 up to form a partnership. Your partner contributes cash and you contribute a building worth $100,000 that has a tax basis of $40,000. The tax basis is determined by the current taxable amount which includes gain and loss values.
The Guiding Principle of Tax Accounting for Partnerships
The above example illustrates an important concept of partnership tax accounting: that the partnership is viewed as an aggregate of the partners. While the partnership itself is the tax reporting entity, the individual partner is the taxpayer. When evaluating partnership tax issues, tax laws treat the activities of the business as though the individual partners conducted the transactions.
When the partnership incurs a liability, it’s as though the partners borrowed money and then loaned it to the partnership, which increases their inside basis. When the partnership pays a liability, it’s as though the partnership distributed money to the partners, who then repaid the liabilities. Therefore, to determine the tax consequences of a partnership transaction, a partner’s capital account is the starting point, but it must be adjusted for the partner’s share of the company’s liabilities, and for any inside/outside basis differences, such as in the example above.
Another implication is that the partners are considered to have earned income in the same manner as it was generated by the partnership. Capital gains must be taxed at different rates from ordinary income; this is an important distinction. When reporting annual income or calculating the gain or loss from disposing of a partnership interest, each partner must treat the transaction as though the partner had initiated it..
Schedule a Consultation
Determining the right tax plan for your business partnership is one of the most important decisions you’ll make in forming a new venture. We help our clients determine the tax plan that that best fits their needs by evaluating tax advantages, legal exposure, ease of operation and portability. Schedule a consultation with the tax accountants at 212 Tax & Accounting Services to find out how we can help you comply with U.S. tax laws for partnerships, avoid surprises, and keep more of what you earn.