Basis: inside out or just right?

• Author: Hazel, Kristen E.

Recent decisions from the Tax Court combined with recent legislative and administrative initiatives and an environment where tax planning strategies are often reported in our daily newspapers have each contributed to a public that views tax planning at best with a skepticism and perhaps much worse. With this in mind, consider whether the tax rules can instead be viewed as a means of driving sound economic behavior. Subchapter K of the Internal Revenue Code (the "Code") and the intricate basis rules provide a framework for this thesis.

First, why is basis important? The fundamental principal of Subchapter K is that partners, not the partnership, are subject to tax. (1) In this regard, Subchapter K treats the partnership as an aggregation of its partners and generally imposes tax accordingly. The starting point for this system of taxation is basis. The partner has a basis in its partnership interest and the partnership has a basis in its property. The partner's basis in its partnership interest is equal to the amount of money and the adjusted basis of property contributed by the partner to the partnership. (2) The partnership's basis in the contributed property is equal to the adjusted basis of that property in the hands of the contributing partner, increased by any gain recognized by the partner at the time of the contribution. (3) The partner's basis in its partnership interest is often referred to as its "outside basis" and the partnership's basis its assets is often referred to as "inside basis." At the outset of the partnership inside basis and the partners" collective outside bases are equal and each partner's tax position vis-a-vis its assets, first the contributed assets and following the contribution, the partnership interest, has been preserved. The transaction is economic and the tax consequences correlate to the economic results.

Throughout the life of the partnership, the correlation between inside and outside basis is preserved through the mechanics of Section 704 and Section 705. Section 704 governs the determination of each partner's distributive share of partnership income, gain, loss, deduction, or credit. Section 705 provides the rules for adjusting the partners' bases in their respective partnership interests throughout the life of the partnership.

The operation of Section 704 and Section 705 can be illustrated in a simple example. Assume a simple 50/50 partnership where each partner contributes appreciated property. Partner A contributes property worth $50,000, with a basis of $10,000. Partner B contributes property worth $50,000, with a basis of $30,000. Partner A's basis in its partnership interest is $10,000 and Partner B's basis in its partnership interest is $30,000. In the first year of operations, the partnership has income of $20,000. The partnership agreement complies with Section 704 and the income is...