Balance Sheet Notes

Capital Accounts

Book Capital Account: Determined under 1.704-1(b)(2)(iv)(b) is the capital increased by money
contributed by the partner plus the FMV of property contributed by the partner (net of liabilities) and
income and gain allocated to him (including tax-exempt income) and decreased by the amount of money
and the FMV of property distributed to him and allocations of expenditures, losses and deductions. A
selling partners capital account transfers over to the purchasing partner. 1.704-1(b)(2)(iv)(l).
o Note: Book capital accounts are based on 704(b)
o

Book capital accounts reflect the fair market value of the assets at the time of contribution to
the partnership and distributions from the partnership. For this reason, book capital accounts
capture the true economic arrangement among the partners.
Reflect the partners contribution and distribution of property, and money, and the
partners allocation of gain, gain, income, loss, and deduction on a FMV basis.
Governedby704(b) and applies to most allocations including allocations of book items
and bottom line taxable income (Reg. 1.704- 1(b)(1)(vii).
Book Capital Account Adjustments:
Increases:
Contributions of Money
Contribution of Property (Increase by FMV net of liabilities)
o Note that Ps adjusted basis is not relevant for this purpose
o Net of liabilities is consistent with the fact that liabilities are separately
stated on the balance sheet (A = L + E)
Income or gain allocated to the partner
o Includes tax exempt income
Decreases:
Money Distributed
Property Distributed (FMV - net of liabilities assumed or taken subject to)
Allocation of losses and deductions
Allocation of 704(a)(2)(B) expenses - expenditures that are not deductible and
that cannot be capitalized

The tax capital account is the partners share of the inside basis of the assets less the liabilities
allocable to that partner. Equal to the Partners adjusted basis (book capital is at FMV)
o Tax capital accounts reflect the tax basis of the partnerships assets. Therefore, tax capital
accounts cannot represent (in the aggregate) greater than the total tax basis of the assets (less
any liabilities).
Reflect the partners contribution and distribution of property and money and the
partners allocation of income, gain, loss and deduction based on the partners adjusted
basis in the property.
Governed by 704(c) and may be used to allocate [certain]tax items. Reg.1.704-1(b)(1)(vi).

o Tax capital can deviate from book capital for a variety of reasons, including:
Deprecation
Contributed property with a value different than its ax basis
Revaluation of partnership assets from cost to current FMV

The difference b/t the book and tax capital accounts is the amount of the partners 704(c) gain or
reverse 704(c) allocation.

Book Capital & 704(b)

Why is 704(b) important and why do we need to comply with it?
o If a partnership agreement does not provide for the allocation of income, gain, loss, deduction, or
credit to a partner; or
o Provides for an allocation, but the allocation lacks substantial economic effect;
o Then the partners distributive share shall be determined in accordance with the partners
interest in the partnership a facts and circumstances test. Reg.1.704-1(b)(1)(i).
o

Partners Basis in his Partnership Interest (outside basis)

Understanding ch. 5
Generally
A partners basis in his interest is important for several reasons, including:
o (1) determining the maximum amount of partnership losses he may deduct
o (2) computing his gain or loss on a sale of the interest
o (3) determining the tax consequences of distributions of money or property he receives from the
partnership
Note that a partners basis includes his share of the PSs liabilities
o Thus, a partner requiring additional basis to deduct his full share of the PS losses may obtain it
by increasing his share of PS liabilities (even nonrecourse)
When determination of basis is required: Under Reg. 1.705-1(a)(1), it is only when it is necessary to
calculate his individual tax liability. Basis must be determined in the following instances:
o

(1) To calculate the amount of gain or loss realized when the interest is sold or
exchanged

Gain/loss = [amount realized] [partners basis in his PS interest]

(2) To determine the maximum partnership loss that may be deducted each year
704(d) limits a Ps deduction for his distribute share of losses to the Ps basis in his PS
interest at end of the PS year

(3) To determine whether the P recognizes gain when the PS distributes cash

Under 731(a), a P recognizes gain to the extent that the amount of cash distributed
exceeds the basis in his PS interest

(4) To determine the partners basis in distributed partnership property

Non-liquidating: Under 732(a), a Ps total basis in prop received in a non-liquidating
distribution cannot exceed the basis in his PS interest
Liquidating: Under 732(b), a Ps total basis in all property received in a liquidating
distribution is limited to the basis in his partnership interest

(5) To determine whether the partner recognizes a loss when his interest is liquidated

Under 731(a)(2), a partner recognizes a loss on a liquidating distribution only if:

(a) no property other than cash, inventory, or unrealized receivables is distributed
to him, and
(b) the basis in his PS interest exceeds the sum of the cash and the partnerships
basis in the distributed assets

(6) To determine the adjustments to the basis of PS property resulting from a 754
basis-adjustment election

A partnership that makes a 754 election must adjust the basis of its property whenever a
difference arises between the PSs basis in its property and the bases of the individual
partners interests because of transfers of interests or distributions of property

Determining a Partners initial outside basis in his partnership interest formation

Ps initial basis in a partnership interest (PSI) depends on how the interest is acquired
If the PSI is acquired in exchange for:
o Contribution to the PS initial basis = cash paid + partners basis in property contributed [722]
o A partners promissory note basis of the PSI is zero
Reason: a taxpayers basis for his own promissory note is zero
Note: The basis in the PSI increases as the partner makes principal payments
o Forgiving a partnership debt to the partner basis in the PSI = Ps basis in the canceled
obligation (ordinarily the face amount), limited to the value of the interest when acquired
Under 752, a partner is considered to contribute money to a partnership in an amount equal to his
share of partnership liabilities, and his basis in his OB increases by that [752(a), 722]
o Conversely, if the PS assumes or takes contributed property subject to a partners liability, the
partner is considered to receive a cash distribution equal to the liability and his basis in his PSI
decreases by that amount [752(b), 733]
o

752 Liabilities & Partners outside basis Treated as cash

752(a) & 722 Increase OB for the Ps share of partnership liabilities since its treated as
contributing cash to the PS
752(b) & 733 Decrease OB for any liabilities the partner sheds (assumed by the PS or
taken subject to) since its treated as a cash distribution
Note: Contribution of encumbered property
because the partnership assumes the liability from the partner, there is a
simultaneous decrease in the contributing partners liabilities and an increase in
his share of partnership liabilities
FIGURE OUT

A partner who performs services in exchange for a PSI is treated as if (1) he received an undivided
interest in the partnerships property equal to the value of his services, and (2) he contributed that
property in exchange for his partnership interest
o P reports the value of the PS property he is deemed to receive as compensation income (which is
also the amount of his basis)

Continuing Adjustments to Partners Outside Basis in his partnership interest operations

A partner's initial outside basis is adjusted (under IRC Sec. 705) to reflect subsequent allocations of
rpartnership items. Ordinarily, basis calculations are made at yea rend. However, certain events
require a basis calculation at interim dates.
Each partners basis in his partnership interest is continually adjusted to reflect his share of the PSs
income, expenditures, and distributions
Outside Basis is increased by:
o

(1) Additional contributions made to the partnership

The increase = amount of cash given + partners basis in prop contrib [722]
Note: Cash includes amount of increase of Ps share of PS liabilities

(2) Partners distributive share of partnership taxable income [705(a)(1)(A)]

Note: This includes the Ps share of overall taxable income and his share of separately
stated items
(3) Partners distributive share of partnership tax-exempt income [705(a)(1)(B)]

Outside Basis is decreased by:

(1) Distributions received from the partnership

o
o

Note: OB cant decrease below zero

The decrease = amount of cash and/or the partnerships basis in the distributed property
[705(a)(2), 733]
A partner is considered to receive a cash distribution = amount of any decrease in the
partners share of PS liabilities and the basis of his PSI also decreases by that amount
[752(b), 733]

(2) Partners distributive share of partnership losses [705(a)(2)(A)]

(3) Partners distributive share of non-deductible partnership expenses that are not

capital expenditures [705(a)(2)(B)]

705(a)(2)(B) tells a Partner to decrease his OB by his distributive share of PS
expenditures that are not deductible in computing its taxable income and not properly
chargeable to a capital account
This rule ensures that a P does not eventually obtain a tax benefit for the expenditure by
decreasing the gain (or increasing the loss) he realizes when he sells or liquidates his PS
interest.
Thus, the rule applies only to expenses that reduce the value of PS assets and not to capital
expenditures which merely change the kind of assets the PS owns
IF NECESSARY LOOK AT SOME EXAMPLES ON UNDERSTANDING PAGE 148
Notes on basis adjustment for taxable income or loss
o A Ps OB increases or decreases by his distributive share of the PSs taxable income or loss under
705(a)(1)
This basis adjustment occurs at the end of the year under 1.705-1(a)(1)
The increase in basis is allowed because he gets taxed on that amount regardless of
whether any money is distributed to him [702, 706(a)]
The decrease for losses is because the losses are reported on his individual tax return
o Note that under 704(d) a partner cannot deduct partnership losses below his OB
This limits the amount of deductible losses to the amount of his positive OB
Rule: Losses that cannot be deduct due to the zero basis limitation can be carried
over and deducted at the end of the subsequent year (assuming sufficient basis
then) Reg. 1.704-1(d)(1)
o Carries forward until deductible not sure if expires

Outside basis computation during the year only occurs in 2 situations:

(1) The partnership tax year closes for a partner before its normal end because the partner sold or
liquidated his entire partnership interest.
o In that situation, the P must compute his year-end basis as of the sale or liquidation date
(2) Determining the consequences of a distribution
o A partner must know the basis of his partnership interest before the end of the PS tax year to
determine the consequences of a distribution.
o The P is taxable to the extent that a cash distribution exceeds the basis of his PSI
immediately before the distribution
o Note: If P receives prop in the distribution, his basis cannot exceed the basis of his PSI at the
time of distribution

In this situation, the P computes the basis of his interest immediately before the
distribution by taking into account any contributions or distributions (including
constructive contributions or distributions resulting from liability changes) and any
basis transfers occurring up to that time

Basis adjustment on sale, exchange, or liquidation of partnership interest

On the day a partner sells, exchanges, or liquidates his entire partnership interest, the selling partner
must determine his distributive share of PS income or loss up to that date and report it on his individual
tax return [706(a), 706(c)(2)(A)]
In determining the tax consequences of the sale, exchange, or liquidation, the partners basis in his PS
interest increases or decreases to reflect his distributive share as well as any other

adjustments required for the portion of the year preceding disposition [1.705-1(a)(1), 1.706-1(c)(2)]
Note: The PSs tax year does not close for a partner selling less than his entire partnership interest
o To determine gain or loss, the selling partner computes the basis in his entire interest on the date
of the sale as if he were selling his entire interest - 704(d)
He then allocates a portion of that basis to the portion of the partnership interest that
was sold

Order of Basis Adjustments

NOT SURE OF THE RELEVANCE OF THIS

Understanding p. 158
Partnerships Basis in its Assets (inside basis)
Partnership must know the basis in each of its assets to:
o (1) compute the amount of its allowable depreciation or amortization
o (2) Determine the amount of g/l it realizes on a disposition of property
o (3) Determine a partners basis in property the PS distributes to him (P generally takes the same
basis the PS had at time of distribution)
A partnerships initial basis in an asset depends on how it was acquired
o
o
o
o

Contributed property partnership takes a carry over basis from the partner equal to the
partners basis in the asset immediately before the contribution - 723
Purchased property cost basis under 1012
Gift property donors basis under 1015
The initial basis is adjusted to reflect depreciation, depletion, deferred expenses, partial
dispositions, etc.

Partnership must adjust the basis in its assets when a 754 election has been made
o Generally, events that change a partners outside basis do not affect the partnerships inside basis.
However, that is not the case when the PS has made a 754 election
o When a 754 election has been made, the partnerships inside basis is adjusted:
(1) When a PS interest is transferred by sale or exchange
The basis of PS prop is adjusted to reflect differences between a new partners
basis in his partnership interest and his proportionate share of the total basis of
the partnerships assets
(2) When a PS distributes cash or property with a basis exceeding the recipient partners
basis in his PS interest

The basis of assets retained by the PS is adjusted to reflect any gain the partner
recognizes on a cash distribution and any reduction in the basis of the distributed
property
FIGURE THESE OUT WHEN YOU GET THERE

Relationship between the partnerships inside basis and the partners outside basis
When a partnership begins, each partners basis in his partnership interest equals the basis in the
property he contributes, and the partnerships basis in the contributed property carries over from the
partners [722, 723]
o Consequently, the partnerships total inside basis for its assets equals the sum of all the partners
outside bases
o This generally remains true and the IB and OB remain equal because the various adjustments to
the PSs IB resulting from operations are the same as the adjustments to the basis of the
partners partnership interests
SEE Example on p. 163 of Understanding
Ex: if PS earns $20k cash and has $6k of depreciation, then the IB is increased by
the cash and the buildings basis is decreased by the depreciation, for a total
increase of $14k. The 2 partners distributive share of PS income is $7k each [(20k
earned 6k depreciation) * 1/2 = $7k), and each Ps OB is adjusted to reflect his
share of PS income
Events that Upset Equivalence of Inside basis and Outside basis
o When the following events occur, the PSs IB partners total OB:
o

(1) A partner acquires a partnership interest through a sale or exchange

o
o

The new Ps basis in his PS interest is its cost, and total outside basis increases or
decreases to reflect his share of the current value PS assets
This change in OB does not affect the IB of the PSs assets
See example p. 164

(2) A partner dies

(3) A partnership distributes cash or prop with a basis exceeding the recipient

partners OB
Although the total basis of PS assets decreases by its basis in the distributed property, the
recipient partners OB cannot decrease below zero under 733. Therefore, the decrease in
the partnerships IB exceeds the decrease in the partners OB.
Restoring Equivalence: 754 Election
o Most disparities between the PSs IB and the partners total OB are eliminated if the partnership
has a basis adjustment election under 754 in effect when the transfer or distribution creating the
disparity occurs.
Under the election, the bases of PS assets are adjusted under 743(b) (for transfers of
interests) or 734(b) (for distributions) in a manner that restores equality between IB and
OB
o If no 754 election has been made, disparities between IB and OB change the timing and
character of a partners income
A P whose OB exceeds his proportionate share of the PSs IB generally realizes more
taxable income from PS operations than he would if no disparity existed
This occurs because the lower basis of PS assets results in smaller depreciation
deductions and more gain when PS assets are sold.
However, the Ps increased income is offset when he disposes of his PS interest

Because the basis in his PS interest is increased by his distributive share of PS

income, he realizes less gain (or a greater loss) when he sells or liquidates the
interest
Although the Ps total gain or loss may be the same, he loses the time value of his tax dollars
In addition, because the sale/liquidation of a PS interest is generally treated as the sale of
a capital asset under 741 (to the extent of 751 applying), the partner may be limited to a
capital loss when he sells his PSI, even though his distributive share of PS income was
ordinary

Relationship between Partners Basis and Capital Account

A partnership keeps track of each partners economic investment in the partnership through a capital
account.
Although capital accounts are maintained for financial purposes, the amount and timing of adjustments
to them usually are governed by tax (rather than GAAP) rules in order to have SEE (or for some reason
like that. Doesnt matter)

A partners opening capital account generally equals the value of his contribution to the PS (e.g., cash
plus the net value of any contributed property). As the PS continues in existence, the capital account
increases or decreases to reflect the partners share of PS income or loss and withdrawals.
o Ordinarily, capital accounts are not adjusted when the value of the partnership assets change and
therefore they do not reflect the current value of the partnership interests
o The value of a PS interest can be determined by assuming a hypothetical sale of a the PS assets
and then crediting the partners accounts for the cash that would be received.
Note that in limited circumstances, a PS may adjust its capital accounts to reflect the
current value of PS property if necessary for certain business purposes described in Reg.
1.704-1(b)(2)(iv)(f) (revaluation of capital accounts)
o This Understanding book just kind of trailed off.

Stopped at the effect of liabilities on page 169