Partners' basis and distribution rules are crucial in understanding partnership taxation. These concepts determine how partners report income, losses, and distributions from the partnership. They also impact the tax consequences of transactions between partners and the partnership.

Proper calculation of partner basis and adherence to distribution rules are essential for accurate tax reporting. These rules affect partners' ability to deduct losses, receive tax-free distributions, and recognize gains or losses on partnership transactions. Understanding these concepts is key to effective tax planning for partnerships.

Partner Basis in Partnership Interest

Initial Basis Calculation

• Partner's initial basis determined by value of contributions made to partnership (cash, property, services rendered)
• Property contributions generally become partner's initial basis in partnership interest, subject to adjustments
• Liabilities assumed by partnership increase initial basis, relief of liabilities decreases it
• Partner's share of partnership liabilities included in initial basis calculation, based on profit and loss sharing ratio
• Aggregate of partner's capital account and share of partnership liabilities typically equals initial basis in partnership interest

Special Considerations

• For property contributions subject to liabilities, partner's basis adjusted for portion of liability assumed by partnership
• When receiving partnership interest for services, partner's initial basis starts at zero and increases as income is recognized
• Partners must maintain accurate records of initial basis for future tax calculations and potential gain/loss recognition
• Initial basis impacts partner's ability to deduct losses and receive tax-free distributions

Tax Consequences of Distributions

Cash Distributions

• Generally tax-free to extent of partner's adjusted basis in partnership interest
• Distributions exceeding adjusted basis result in taxable gain, typically treated as capital gain
• Example: Partner with $10,000 adjusted basis receives $12,000 cash distribution, recognizes $2,000 capital gain
• Reduces partner's basis in partnership interest by amount of distribution

Property Distributions

• Generally tax-free, partner takes carryover basis in distributed property
• Carryover basis limited to partner's adjusted basis in partnership interest
• Partnership's basis in distributed property reduced by amount allocated to receiving partner
• Example: Partnership distributes property with $15,000 basis to partner with $12,000 adjusted basis, partner's basis in property limited to $12,000
• Special rules apply for marketable securities, often treated as cash for tax purposes (may trigger gain recognition)

Impact on Capital Accounts

• Distributions reduce partner's capital account
• May affect future profit and loss allocations
• Partners must consider long-term impact on ownership percentage and economic interests

Hot Assets and Distributions

Defining Hot Assets

• Unrealized receivables (amounts not yet reported as income)
• Inventory items with substantially appreciated value (fair market value exceeds 120% of partnership's adjusted basis)
• Examples: Accounts receivable, work in progress, LIFO recapture amounts

Tax Implications of Hot Asset Distributions

• Can trigger ordinary income recognition for receiving partner
• Overrides general tax-free treatment of property distributions
• Amount of ordinary income limited to partner's share of partnership's hot asset basis minus basis of hot assets actually distributed
• Example: Partner's share of hot asset basis is $50,000, receives distribution with $30,000 hot asset basis, potential $20,000 ordinary income recognition

Impact on Partnership Interest Sales

• Distribution of hot assets affects character of gain on sale/exchange of partnership interests
• Portion of gain attributable to hot assets treated as ordinary income
• Remaining gain generally treated as capital gain

Basis Adjustments for Distributions and Transfers

Section 734(b) Adjustments

• Optional basis adjustments to partnership property following certain distributions
• Triggered by gain/loss recognition on distribution or basis reduction in distributed property
• Allocated among remaining partnership assets according to rules in Section 755
• Example: Partnership distributes property with $100,000 basis to partner with $80,000 basis in partnership interest, $20,000 basis reduction allocated to remaining assets

Section 743(b) Adjustments

• Mandatory or elective basis adjustments when partnership interest transferred by sale, exchange, or death
• Adjusts incoming partner's share of partnership's basis in assets to reflect purchase price or inherited basis
• Only affects basis for transferee partner, not entire partnership
• Example: Partner buys interest for $200,000, partnership's basis in assets attributable to that interest is $150,000, $50,000 positive basis adjustment allocated to partnership assets

Section 754 Election

• Enables partnership to make Section 734(b) and 743(b) basis adjustments
• Once made, applies to all future qualifying transactions
• Can provide tax benefits to incoming partners or distributees
• Affects future depreciation deductions, gain/loss recognition on asset sales, and tax treatment of subsequent distributions