The function of basis.

• Author: Ellentuck, Albert B.

The fundamental purpose of outside basis is to account for a partner's after-tax investment in the partnership. Outside basis determines how much a partner may withdraw or deduct from a partnership for tax purposes without recognizing additional gain or without being limited on the allowable flowthrough of partnership losses. Because of the flowthrough, single-level taxation scheme of Subchapter K where partners, not the partnership, are taxed on partnership-level transactions, a method is needed to account for each individual partner's (1) contributions and distributions; (2) allocation of profits and losses; and (3) acquisition cost for his or her partnership interest (other than by contribution). The basis calculation rules keep track of the partner's basis (i.e., his or her cost basis or after-tax investment in the partnership). The calculated basis determines the tax impact of certain transactions (e.g., if a partner receives a distribution in excess of his or her accumulated investment in the partnership).

Reducing a partner's basis in partnership interest

A partner can use only two methods to withdraw money or property from a partnership: (1) a distribution or (2) a sale or other disposition of the partner's interest. (This excludes borrowing, which is only temporary, and compensation, which is not, per se, a partnership transaction.) The flowthrough of partnership losses is one additional event that reduces a partner's after-tax investment. These three situations are the only means by which a partner recovers part or all of his or her outside basis in the partnership interest. The function of basis is to make sure that, over the partnership's life, the partner does not withdraw more or less than his or her investment without some tax impact.

To the extent that the partner merely withdraws his or her previously taxed investment in a partnership, there is no tax impact other than a reduction of the partner's basis in the partnership interest. If a partner withdraws more than his or her previously taxed investment, whether by distribution or as a result of the disposition of his or her interest, he or she must report a gain (Secs. 731(a)(1) and 741). If, over the life of the partnership, the sum of the partner's distributions and the amount received on disposition are less than the partner's tax investment in the partnership, he or she reports a loss (Secs. 731(a)(2) and 741). If the partnership attempts to allocate the partner more loss than the remaining outside basis in his or her...