Tax basis is the amount upon which taxable gain or loss, if any, will be calculated on the occurrence of various events, including but not limited to the disposition of an asset or sale of an interest in an entity.
Although general partnerships created under state law are relatively rare these days, the principles of federal partnership taxation, set forth in Subchapter K of the Internal Revenue Code (“IRC”), are applicable to various types of more common entities by default, e.g. a multiple-member limited liability company (“LLC”).
The contribution of an asset to an entity taxed under Subchapter K of the IRC affects or necessitates at least four distinct calculations: 1) Book Value, 2) Inside Basis, 3) Outside Basis, and 4) Capital Accounts.
Upon contribution of an asset, an entity is said to “book” the value of an asset using the current fair market value of the asset.
For example, if Jack contributes an asset to an entity that Jack purchased for $50 but now has a fair market value of $100 and Jane contributes an asset that she purchased for $75 but now has a fair market value of $25, the entity will enter the value of the assets on its books as being $100 and $25, respectively.
The entity’s tax basis in an asset, called inside basis, is the same as the contributing person’s basis in the asset.
Continuing with the previous example, the entity will have a tax basis, or inside basis, of $50 in the asset that Jack contributed, while the entity will have an inside basis of $75 in the asset that Jane contributed.
Unlike book value and inside basis, outside basis and capital accounts don’t reference an asset; rather, they reference a person’s interest in an entity.
In return for a person’s contribution to an entity, the person receives an interest, e.g. a partnership interest or an ownership interest, in that entity, which may consist of units, a participation percentage, a capital account, etc., for which interest that person is given a tax basis, called outside basis, equal to the tax basis of the asset contributed. Unlike book value, outside basis is determined at the interest holder, e.g. LLC member, level.
Continuing with the previous example, Jack’s outside basis in his interest in the entity is $50, but Jane’s outside basis is $75.
In this example, both the inside and outside bases are the same, however, various events can cause the bases to be different.
In general, a person’s capital account consists of the book value of any assets contributed by that person minus any distributions to that person from the entity and/or liabilities to the entity.
Continuing with the example above, Jack’s capital account balance is $100, his outside basis is $50, the entity’s inside basis in the asset is $50, and the book value of the asset is $100. Further, Jane’s capital account balance is $25, her outside basis is $75, the entity’s inside basis in the asset is $75, and the book value of the asset is $25.
This brief overview of some important considerations associated with inside basis, outside basis, and partnerships is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.
Douglas K. Cook is an attorney with over 40 years of experience. Although Cook & Cook's office is located in Mesa, Arizona, the attorneys at Cook & Cook represent clients throughout the Phoenix, Arizona Metropolitan area including the following east valley cities: Scottsdale, Paradise Valley, Tempe, Chandler, & Gilbert.