Inside v. Outside basis – WTF is THIS a Big Deal?

Inside v. Outside basis – WTF is THIS a Big Deal?

12/07/2024|John R. Dundon II, EA|

Inside v. Outside basis – WTF is THIS a Big Deal?

Partnerships

In a partnership, the terms inside basis and outside basis refer to different aspects of how the partnership and its partners account for the tax basis. These concepts are crucial for understanding how a partner’s interest in the partnership is valued for tax purposes and how gains or losses are calculated when certain events occur, such as distributions or the sale of a partnership interest.

Inside Basis

The inside basis refers to the partnership’s basis (or tax value) in its own assets. In other words, it’s the value the partnership assigns to each asset it owns for tax purposes. This is important because the partnership will use the inside basis to calculate depreciation, amortization, and gains or losses on selling those assets.

  • The inside basis is determined by the contribution of assets by partners when the partnership is formed and can be adjusted over time (e.g., due to depreciation or additional contributions).
  • If a partner contributes property to the partnership, the partnership’s inside basis in that property is generally equal to the partner’s original basis in the property, not its fair market value.
  • The inside basis also increases when the partnership buys additional assets or invests in capital improvements.

Outside Basis

The outside basis refers to a partner’s basis in their respective partnership interest. It represents the partner’s investment in the partnership and is used to determine the tax consequences of distributions from the partnership and the sale or exchange of the partnership interest.

  • When a partner contributes cash or property to the partnership, their outside basis is initially equal to the amount of money contributed plus the adjusted tax basis of any property contributed.
  • The outside basis is adjusted over time for the partner’s share of the partnership’s income, losses, distributions, and liabilities. For instance, the partner’s outside basis increases when they are allocated a share of the partnership’s income or if they contribute additional capital. It decreases if the partner receives a distribution or is allocated a share of the partnership’s losses.

Key Differences

  1. What is being measured:
    • Inside Basis: The partnership’s basis in its assets.
    • Outside Basis: The partner’s basis in their partnership interest.
  2. Impact on taxes:
    • Inside Basis: Used to calculate the partnership’s taxable income from the sale or usage of assets (e.g., depreciation, gain on sale).
    • Outside Basis: Used to determine the tax consequences for the individual partner, such as the recognition of gain or loss on the sale of the partnership interest or distributions.
  3. Adjustments:
    • Inside Basis: Adjusted by events affecting the partnership’s assets (e.g., purchases, sales, and depreciation).
    • Outside Basis: Adjusted by events affecting the partner’s involvement in the partnership (e.g., income, losses, distributions, and liabilities).

Example

Imagine two partners, Alice and Bob, forming a partnership. Alice contributes $50,000 in cash, and Bob contributes a piece of land with an adjusted tax basis of $50,000 (though its market value might be higher).

  • The inside basis of the partnership in the land is $50,000 (the basis Bob had in the land), and the inside basis of the partnership in the cash is $50,000 (the cash Alice contributed).
  • Alice’s outside basis is $50,000 (her contribution of cash), and Bob’s outside basis is also $50,000 (his adjusted tax basis in the land he contributed).

Over time, if the partnership generates income, Alice and Bob’s outside bases will increase by their share of the income. Similarly, if the partnership distributes cash or property to the partners, their outside bases will decrease accordingly.

The Internal Revenue Code (IRC) and Treasury Regulations provide specific rules governing the determination and adjustments to both inside basis (the partnership’s basis in its assets) and outside basis (a partner’s basis in their partnership interest). Below are the relevant sections:

Inside Basis

The rules related to the inside basis of partnership assets are primarily found in the following sections:

  • IRC § 723: Basis of property contributed to a partnership. This section governs the basis of property contributed to a partnership by a partner, stating that the partnership’s basis in the contributed property is generally the same as the contributing partner’s adjusted basis in the property at the time of contribution (often referred to as a “carryover basis”).
  • IRC § 705(a): Determination of basis of partner’s interest. Though this section primarily covers outside basis, it also provides rules about adjustments to basis that indirectly impact the inside basis (e.g., income, loss, and distributions).
  • IRC § 734(b): Adjustment to basis of undistributed partnership property. This section addresses situations where partnerships can adjust the inside basis of their assets after certain distributions to partners, specifically when a Section 754 election is made.
  • IRC § 743(b): Adjustment to basis of partnership property. This section allows for adjustments to the inside basis of partnership assets when there is a transfer of a partnership interest, again contingent on the partnership having made a Section 754 election.
  • Treasury Regulation § 1.723-1: This regulation provides additional detail on the application of IRC § 723, specifying how the partnership takes a basis in contributed property.
  • Treasury Regulation § 1.734-1: This regulation provides guidance on the adjustments to the basis of undistributed property when there is a distribution that triggers a basis adjustment under IRC § 734.

Outside Basis

The outside basis of a partner’s interest in the partnership is governed by these sections:

  • IRC § 722: Basis of contributing partner’s interest. This section states that when a partner contributes property or cash to a partnership, the partner’s outside basis is generally equal to the amount of cash contributed or the adjusted basis of the property contributed.
  • IRC § 705(a): Determination of basis of partner’s interest. This section governs the determination of a partner’s outside basis, which is adjusted for the partner’s share of income, losses, and distributions. It outlines the adjustments to outside basis for a partner’s share of partnership income, losses, and other events.
  • IRC § 752: Treatment of certain liabilities. This section deals with how a partner’s outside basis is affected by partnership liabilities. Specifically, a partner’s share of partnership liabilities increases their outside basis, while a decrease in liabilities decreases their outside basis.
  • Treasury Regulation § 1.705-1: This regulation explains the adjustments to a partner’s outside basis in more detail, particularly adjustments for taxable income, losses, and distributions.
  • Treasury Regulation § 1.752-1: This regulation provides details on how liabilities are allocated among partners and how the assumption of liabilities impacts a partner’s outside basis.

In summary

The inside basis deals with the partnership’s view of its basis in its assets, while the outside basis concerns the individual partner’s tax basis in the partnership interest. Both are essential for determining tax liabilities related to partnership activities and transactions.

S-corporation

When comparing a partnership to an S-corporation, the concepts of inside and outside basis remain important, but there are significant differences in how they are treated due to the distinct legal and tax structures of these two entities. Below is an explanation of the differences in basis rules for an S-corporation and how they compare to a partnership.

Key Differences Between Partnerships and S-Corporations

  1. Entity Structure:
    • A partnership is a pass-through entity where the partners share ownership of the entity’s assets and liabilities.
    • An S-corporation is also a pass-through entity for tax purposes, but it is a corporation in legal form. This means the corporation, not the shareholders, owns the assets and liabilities of the business.
  2. Liabilities:
    • In a partnership, a partner’s outside basis includes their share of the partnership’s liabilities under IRC § 752.
    • In an S-corporation, shareholders’ stock basis does not include corporate liabilities. This is because the corporation is liable for its own debts, and shareholders are not directly responsible for S-corporation liabilities unless they personally guarantee them.

Inside and Outside Basis in an S-Corporation

Outside Basis in an S-Corporation

The outside basis in an S-corporation refers to a shareholder’s basis in their stock. Like partnerships, the basis in an S-corporation is crucial for determining a shareholder’s ability to deduct losses and the taxability of distributions. However, the calculation and adjustments differ somewhat from those in a partnership.

  • Initial Basis: A shareholders’ outside basis in an S-corporation starts with the amount paid for the stock or the adjusted basis of property contributed in exchange for stock.
    • IRC § 358 governs the basis of property received in exchange for stock in corporate formations, including S-corporations.
  • Adjustments to Basis:
    • Increases to Basis: The shareholder’s basis is increased by their share of the S-corporation’s income (including tax-exempt income), capital contributions, and any gain recognized on a loan repayment to the shareholder.
      • IRC § 1367(a)(1) governs the upward adjustments to the basis for an S-corporation shareholder.
    • Decreases to Basis: The shareholder’s basis is decreased by their share of the corporation’s losses, distributions (generally tax-free to the extent of basis), and non-deductible expenses.
      • IRC § 1367(a)(2) governs the downward adjustments to the basis for an S-corporation shareholder.
  • S-Corporation Loans to Shareholders: If a shareholder loans money directly to the S-corporation, they receive a basis in the debt, separate from their stock basis. This “loan basis” allows the shareholder to deduct losses that exceed their stock basis, but only to the extent of their loan basis. If the loan is repaid, the shareholder must reduce their loan basis accordingly.
    • IRC § 1366(d) limits the deduction of losses to the sum of stock and debt basis.

Inside Basis in an S-Corporation

The inside basis in an S-corporation refers to the corporation’s basis in its own assets, like a partnership. However, because an S-corporation is a separate legal entity, the shareholders do not have a direct interest in the corporation’s assets or liabilities.

  • Initial Basis of Assets: Like a partnership, the S-corporation’s initial basis in its assets is determined by the adjusted basis of the contributed property or the cash used to purchase the assets.
    • IRC § 362 governs the basis of property that a corporation receives from its shareholders in exchange for stock.
  • Adjustments to Inside Basis: The S-corporation adjusts its inside basis of assets for depreciation, amortization, and any gain or loss on the sale of assets.
    • Unlike in a partnership, adjustments to the corporation’s inside basis do not affect the shareholders’ basis in their stock, except indirectly through income or loss allocations.

Key Differences in Basis Treatment Between S-Corporations and Partnerships

1. Liabilities’ Effect on Basis:

  • Partnership: Partners include their share of partnership liabilities in their outside basis (under IRC § 752).
  • S-Corporation: Shareholders do not include corporate liabilities in their stock basis. The only exception is if they personally guarantee corporate debt, but even then, it doesn’t increase their stock basis—it would only affect their ability to claim losses if they have a direct loan to the corporation (creating debt basis).

2. Basis in Debt:

  • Partnership: Partners can increase their outside basis by their share of partnership liabilities and use that increased basis to deduct losses.
  • S-Corporation: Shareholders can obtain a debt basis only if they directly loan the S-corporation. Shareholders cannot increase their stock basis by the corporation’s liabilities.

3. Distributions:

  • Partnership: Distributions reduce a partner’s outside basis and are generally tax-free to the extent of basis. Distributions exceeding basis result in taxable gains.
  • S-Corporation: Distributions are tax-free to the extent of a shareholder’s stock basis (not debt basis). If distributions exceed stock basis, they are treated as capital gains.

4. Loss Deductions:

  • Partnership: Partners can deduct losses to the extent of their outside basis, including their share of partnership liabilities.
  • S-Corporation: Shareholders can deduct losses only up to the extent of their combined stock and debt basis. Shareholders do not get the basis for the corporation’s liabilities unless they have made loans directly to the S-corporation.

Example of S-Corporation Basis

Let’s say Alice owns 100% of an S-corporation. She contributes $50,000 to start the business, and the corporation borrows $100,000 from a bank.

  • Alice’s initial outside basis (stock basis) is $50,000, equal to her cash contribution.
  • The inside basis of the corporation’s assets is $50,000 (the cash it received from Alice), plus any additional basis for assets it purchases with the $100,000 loan.
  • Alice’s stock basis will increase with her share of the corporation’s income and decrease with her share of losses and any distributions.
  • The $100,000 bank loan does not affect Alice’s stock basis, as it is a liability of the S-corporation, not Alice personally.

Suppose Alice loans the S-corporation $20,000 directly. In that case, she will receive a debt basis of $20,000 in addition to her stock basis, allowing her to deduct additional losses up to the combined stock and debt basis.

Here are links to the relevant Internal Revenue Code (IRC) sections and Treasury Regulations on the IRS and other official government websites:

Inside Basis

Outside Basis

Conclusion

While both partnerships and S-corporations are pass-through entities for tax purposes, the basis rules differ in significant ways:

  • Partnerships allow partners to include their share of liabilities on an outside basis, which increases their ability to deduct losses.
  • S-corporation shareholders do not get a basis for corporate liabilities, except for loans they make directly to the corporation. Shareholders have separate stock basis and debt basis, which are treated differently for loss deduction and distributions.

Understanding these differences is crucial for determining tax consequences in each entity structure.

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