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What is the difference between inside and outside basis for partnerships?
How does it work?
In this article, I will break down the notion of Inside Basis vs Outside Basis so you know all there is to know about it!
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Let’s look at the inside vs outside basis to better understand their distinction!
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Inside Basis vs Outside Basis Overview
The notion of inside basis in relation to a partnership refers to the partnership’s basis in a partnership asset and how it reflects that basis in each partner’s capital account.
On the other hand, an inside basis refers to a partner’s interest in all of the partnership assets.
Let’s look at a quick example to illustrate this.
Imagine that you have Mary, Suzane, John, and Jack who form a partnership where they each contribute $250,000 to the partnership.
The contributions total $1,000,000 and each partner has a $250,000 outside basis in the total partnership equity (the partner’s basis on all the partnership assets).
Now the partnership takes the $1,000,000 and buys a piece of land costing the partnership $1,000,000.
If this piece of land appreciates in value (by $200,000), then the land will have an inside basis of $300,000.
Each partner will therefore have an outside basis of $250,000 (their contribution to the partnership) and an inside basis of $300,000 (representing their share in the fair market value of the land).
What Is A Partnership
A partnership refers to a business structure where two or more people unite their resources, knowledge, and effort to run a commercial operation where they will share the profits and liabilities.
At the end of the fiscal year, each partner will then have to report the proportion of business profits or losses on his or her income tax statement as per the US Internal Revenue Code requirements.
To establish how much the partners will be required to pay in taxes at the end of the fiscal year, their adjusted tax basis must be established.
Types of Tax Basis
A partnership has two types of taxis basis: inside basis and outside basis.
The inside basis refers to the tax basis of assets owned by the partnership whereas the outside basis refers to each partner’s interest in the partnership.
For instance, Mary contributes $50,000 in cash to a partnership she forms with John and John contributes property having a market value of $50,000 (but originally purchased for $20,000).
In this case, Mary and John’s outside basis will be equal as they each contributed $50,000 to the partnership that now has total equity of $100,000.
However, Mary and John’s inside basis will be different.
Mary will have an inside basis of $50,000 whereas John will have an inside basis of $20,000 (as that’s how much he had paid for the property before it was contributed to the partnership).
If Mary sells her share in the partnership for $50,000, she will not realize any capital gains and will have no taxes to pay.
However, if John sells his interest in the partnership, he will realize a capital gain of $30,000.
Flow Through Entities
There are different types of entities that may have to account for the owner’s basis to reflect the assets owned by the business and the owner’s interest in the company.
Partnerships are pass-through entities that must flow income and expenses to the partners so they can declare their share on their personal income taxes.
S-Corporations also follow the same basis concept to determine a shareholder’s basis the same way as a partnership with some adaptations (for example, the liabilities will not be considered the same way).
Limited liability companies (LLCs) that are flowing income and losses to their members will also need to take into account each member’s basis along with the LLCs basis when dealing with property.
Internal Revenue Code
Section 754 of the Internal Revenue Code requires that every partner calculate its adjusted basis to determine his or her tax liability.
This is an important tax rule that must be respected particularly to allow the partners to determine how much they can receive in profits (or losses) at the end of a fiscal year.
It’s important to determine the inside and outside basis for tax purposes so the partners can pay the proper taxes on the partnership profits and losses.
If you are looking to start a partnership or are involved in a partnership and have specific questions relating to your tax obligations, you should consult a tax attorney or tax accountant for advice and guidance.
Difference Between Inside And Outside Basis
Let’s look at the difference between the inside vs outside tax basis to better understand the notion.
The “inside basis” refers to the adjusted basis relating to each asset owned by the partnership.
By determining the inside basis of an asset held by the partnership, every partner will know how much tax liability they may have in relation to the asset in question.
For example, a partner may contribute land to the partnership having a tax basis of $10,000 but having a fair market value of $50,000.
In this case, if the partnership asset is sold at its fair market value, there will be a $40,000 capital gain that must be recognized by the partner having contributed the asset.
The inside basis is determined based on the contributions made by the partners to the partnership or by assets purchased directly by the partnership using the partnership funds.
The “outside basis” refers to a partner’s share in the entire partnership and all its assets.
When partners get together to start a partnership, they will each make contributions to the partnership based on which their outside basis will be determined.
For example, if John contributes $50,000 in cash to the partnership and Mary brings land having an inside basis of $10,000 but a fair market value of $50,000, then both Mary and John will have an equal interest in the partnership (thus, the same outside basis).
Since the value of John’s contribution is $50,000 and the fair market value of Mary’s contribution is $50,000 as well, the total partnership contribution is $100,000 and each Mary and John have an equal outside basis in the partnership.
Partnership Retained Earnings
When the partnership generates revenues, the partners will have to pay taxes on those earnings regardless of the fact that the partnership has effectively distributed the earnings to them or not.
From a tax perspective, the partners have to pay taxes on their share of the partnership earnings and it is irrelevant if the partnership kept those earnings or not.
Typically, when earnings are recorded, the partnership will distribute the earnings to each of the partner’s capital accounts.
Eventually, if distributions are made to the partners, the distribution will be applied to the same capital account.
Tax Basis Adjustment
A partner’s basis in the partnership will fluctuate over time.
In some cases, the partner’s basis will go up whereas in other cases it will go down.
Here are some reasons when the partner basis may increase over time:
- The partner makes further contributions to the partnership (in cash, property, or service)
- As a result of the partner’s share in the partnership taxable income
- Recognition of income (including tax-exempt income)
- Property depletion deductions
- The increased share in the partnership’s liability
Here are some reasons when the partner’s basis may decrease over time:
- When the partnership distributes money or property to the partners
- Losses that reduce the basis of the partnership asset without any impact on its income
- When the partner’s allocable share of the partnership liabilities is reduced
- Recognition of losses
Partnership Inside Basis And Outside Basis Example
Let’s look at an example of how inside and outside basis is important from a tax perspective.
Imagine you have Mary and John who form a partnership making the following contributions:
- Mary contributes a real estate property having a tax basis of $100,000 and a fair market value of $200,000
- John contributes $200,000 in cash
In this case, Mary’s contribution has a fair market value of $200,000 and John’s contribution in cash is worth the same.
As a result, Mary and John each have a 50% equity in the partnership.
The total inside basis of the partnership is $400,000.
On the other hand, the outside basis for Mary and John will not be the same.
If Mary were to sell her partnership interest for $200,000, she would have to report a $100,000 capital gain as she has an inside basis of $100,000.
On the other hand, if John were to sell his partnership interest for $200,000, he would not have to report any capital gains on it as he has an inside basis of the same aount.
Inside vs Outside Basis Takeaways
So there you have it folks!
What is the meaning of inside basis and outside basis?
How does the inside vs outside basis work for partnerships?
Determining the Inside vs outside basis of a partnership has an impact on how the partners of a partnership are taxed.
The inside basis refers to the partnership’s tax basis in individual assets whereas the outside basis refers to each partner’s interest in the partnership.
Fundamentally, partnerships are pass-through entities (or flow-through entities) where the profits and losses of the business are flown down to each partner in proportion to their partnership interest.
For the partners to divide the partnership interests for tax purposes, they need to follow Internal Revenue Code rules and regulations that particularly require they each calculate their adjusted basis.
In fact, section 754 IRC imposes that every partner in a partnership determine their adjusted basis so they can then determine how much tax they must pay.
When partnerships keep track of every partner’s outside basis and inside basis relating to the assets it holds, it will then flow down the right tax liability to the partners.
I hope that this article helped you better understand the different between the outside basis vs inside basis and how it works for partnerships.
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Outside Basis vs Inside Basis Overview
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