Contributed by: AnthonyS, FreeTaxUSA Agent, Tax Pro
It’s nearing the tax filing deadline, and you finally get a copy of your Schedule K-1 from your partnership. As you enter the information into tax software, it asks questions about partnership basis and distributions. What does all of this mean, and why is the software asking?
This is an all-too-common situation every April and October. Let’s begin by giving a rough explanation of what partnership basis and distributions are, then explain how to calculate basis and what happens when a distribution is greater than your basis.
💡 Note: This article discusses partnership basis only. Basis rules for S corporations and C corporations are different.
What is partnership basis?
Partnership basis is essentially your investment in the partnership that hasn’t been returned to you.
Your basis can come from several sources, including:
- Cash invested in the partnership.
- Property contributed to the partnership.
- Additional contributions made over the life of the business.
- Your share of the partnership's income.
Your basis changes every year depending on what happens within the partnership.
What is a distribution?
A distribution is cash or property the partnership gives back to you.
Unlike your share of the partnership's income, distributions typically aren’t taxable when you receive them. Instead, they reduce your basis because you’re getting part of your investment back.
Why does basis matter?
When the partnership earns income, your share is reported on your Schedule K-1. In most cases, you must report that income on your tax return whether or not you actually receive the money.
If you leave the money in the business, your basis increases because you have already paid tax on your share of the income.
When the partnership later distributes cash to you, your basis is reduced. Since you've already paid tax on that money as passive earnings, the distribution is most likely tax-free.
The sticky part comes when your cash distribution is greater than your adjusted basis. This means you've already recovered all of your investment, and the remaining portion of the distribution hasn’t been previously taxed. In most cases, the amount that exceeds your basis is reported as a capital gain.
Why is the software asking about basis?
Many taxpayers wonder why the tax software asks about basis when the partnership already prepared the Schedule K-1.
The answer is simple. The IRS requires each partner to keep track of their own basis. The partnership may not know your original contributions, prior-year basis, or transactions that occurred outside of the partnership.
The software asks about basis for two primary reasons:
- To determine whether your partnership losses are deductible.
- To determine whether part of a distribution is taxable.
Without knowing your basis, the software can't accurately determine how much of your loss can be deducted or whether a distribution creates taxable income.
How do I calculate basis?
This can be a difficult task depending on your records and the partnership's records. If basis hasn’t been tracked over the years, it can take quite a bit of time and effort to recreate it.
You’ll need to start at the beginning, when the partnership was formed. Ask yourself what money or property you contributed to the business. That amount becomes your initial basis.
From there, your basis will increase or decrease over time.
Generally, the following items increase basis:
- Cash contributions.
- Property contributions.
- Your share of partnership income.
Generally, the following items decrease basis:
- Cash distributions.
- Property distributions.
- Your share of partnership losses.
You’ll need to review each year separately and carry the ending basis from one year into the next until you determine your current adjusted basis.
Basis calculation example
For this example, we’ll follow one partner over a three-year period.
💡Quick Note: Start with your beginning basis + Contributions + Partnership income − Distributions − Partnership losses = Ending basis
Year 1
Bob contributes:
- $5,000 in cash.
- Property with an adjusted tax basis of $750.
His initial basis is $5,750.
During the first year, Bob's share of the partnership's income is $1,000. He leaves all the money in the business and doesn’t receive a distribution.
Beginning basis: $5,750
Plus current-year income: +$1,000
Ending basis: $6,750
Year 2
The company has a very successful year, and Bob's share of the partnership's income is $10,000.
The partnership distributes $5,000 in cash to him.
Bob's basis starts with the ending balance from Year 1.
Beginning basis: $6,750
Plus current-year income: +$10,000
Adjusted basis before distribution: $16,750
Less cash distribution: −$5,000
Ending basis: $11,750
Since his basis was greater than the distribution, the entire $5,000 distribution is tax-free. because he had already paid tax on the partnership income that created it.
Year 3
The company has another profitable year, and Bob's share of the partnership's income is $2,000.
The partnership then distributes $15,000 in cash.
Beginning basis: $11,750
Plus current-year income: +$2,000
Adjusted basis before distribution: $13,750
Cash distribution: −$15,000
The first $13,750 of the distribution reduces his basis to zero and is tax-free.
The remaining $1,250 is greater than his basis and is reported as a capital gain.
His ending basis is now $0.
What if the partnership has a loss instead?
Losses work differently than distributions.
A partnership loss can only reduce your basis to zero. If your share of the loss is greater than your available basis, the excess loss is often suspended and carried forward until your basis increases in a future year.
For example, if your basis is $5,000 and your share of the partnership loss is $7,500, you can generally deduct only $5,000 on your tax return. That deduction reduces your basis to $0. The remaining $2,500 is suspended and carried forward until you have enough basis to deduct it.
Summary
Partnership basis is simply your investment in the partnership that hasn’t been returned to you. It changes every year based on the activity of the business.
In general:
- Contributions and your share of partnership income increase your basis.
- Distributions and your share of partnership losses decrease your basis.
- Cash distributions are tax-free until they exceed your adjusted basis.
- If a cash distribution is greater than your basis, the excess is reported as a capital gain.
- Partnership losses can only be deducted to the extent of your available basis. Any excess loss is suspended and carried forward until your basis increases.
Keeping an accurate record of your basis is important because it determines how much of your partnership losses you can deduct and whether any part of your distributions is taxable. If your basis has never been tracked, you may need to reconstruct it using prior-year tax returns, Schedule K-1s, and partnership records before you can accurately complete your current-year return.