Application of the tax basis and at-risk loss limitations to partners.

• Author: Nevius, Alistair M.

Individuals who invest in partnerships need to be aware of the rules that limit the ability of a partner to deduct losses. Individual partners who have been allocated a distributive share of loss must satisfy three separate loss limitations before the loss can be used. The loss limitations, in the order in which they are applied, include: (1) the Sec. 704(d) basis limitation, (2) the at-risk limitation of Sec. 465, and (3) the passive loss limitation of Sec. 469 (Temp. Regs. Sec. 1.469-2T(d)(6)(i)). This item focuses on the application of the Sec. 704(d) basis limitation and the at-risk limitation for individual partners and does not discuss the application of the passive loss rules.

Loss Limitation Under Sec. 704(d)

Sec. 704(d) provides that a partner's distributive share of loss is allowable to the extent of the partner's adjusted tax basis in his interest in the partnership at the end of the partnership year in which the loss occurred. Any losses in excess of the partner's tax basis are disallowed pro rata (Regs. Sec. 1.704-l(d)) and are carried forward indefinitely for as long as the partner remains in the partnership.

Sec. 705(a) generally provides that a partner's adjusted basis in his interest in the partnership includes the amount of money and the adjusted basis of property contributed to the partnership increased by any gain recognized on the contribution. A partner's adjusted basis is increased by the partner's distributive share of taxable and tax-exempt income and decreased by the partner's distributive share of partnership losses, nondeductible expenditures, and the amount of money and the adjusted basis of distributed property (see, e.g., Rev. Rul. 96-10 and Rev. Rul. 96-11).

A partner's basis is further adjusted by the liability allocation provisions of Sec. 752. Sec. 752(a) provides that an increase in a partner's share of the partnership's liabilities, or any increase in a partner's individual liabilities because the partner assumed those liabilities, is considered a contribution of money by the partner to the partnership. Sec. 752(b) provides that a decrease in a partner's share of a partnership's liabilities, or any decrease in a partner's individual liabilities because the partnership assumed the partner's individual liabilities, is considered a distribution of money to the partner by the partnership.

Example 1: Individual A is a general partner in partnership AS, which invests in a single activity. A has a $6,000 basis in his partnership interest and is allocated 50% of profits and losses. At the end of tax year X1, partnership AB has $10,000 of gross income and $30,000 of expenses, resulting in a $20,000 loss. A's share of this loss is $10,000, and his tax basis (before taking into account his share of the loss) is $6,000. Under Sec. 704(d), A has an allowable loss for the year of $6,000, and his tax basis is reduced to zero. Assume that the allocation to A in this example is valid because A has a deficit restoration obligation, which is an obligation to restore a deficit balance in a capital account. Deficit restoration provisions are used to comply with the requirement that partnership allocations have substantial economic effect (see Regs. Sec. 1.704-l(b)(2)). The excess loss of $4,000 is suspended and carried over.

The regulations under Sec. 704(d) dictate the order in which a partner's tax basis is adjusted for purposes of determining the extent to which a partner's distributive share of loss is deductible. A partner's tax basis is first increased for items of income and then decreased for distributions. Then, a partner's tax basis is decreased by the partner's distributive share of losses from the...