Partnership Tax Navigator
Foundational Principles of Partnership Taxation
This interactive guide explores the core transactions in U.S. partnership tax law. Before diving into specific scenarios, it's crucial to understand the foundational concepts that govern every interaction: the dual basis system and the competing theories of partnership taxation.
The Duality of Basis
Partnership taxation revolves around two related but distinct basis calculations to ensure income is taxed once and only once.
Outside Basis (Partner's Basis)
A partner's basis in their partnership interest itself. It starts with the basis of contributed property and is adjusted for income, losses, and distributions. It determines gain/loss on the sale of the interest.
Inside Basis (Partnership's Basis)
The partnership's basis in the assets it holds. This is used to calculate the partnership's gain/loss on asset sales and for depreciation deductions.
Aggregate vs. Entity Theory
Subchapter K is a hybrid, applying two different theories depending on the transaction.
Entity Theory
Treats the partnership as a separate entity, distinct from its partners. A partner's interest is a single asset like a stock. IRC § 741 is a key example.
Aggregate Theory
Treats the partnership as an aggregation of its partners, who each own a piece of the underlying assets. IRC § 751 "hot asset" rules are a key example.
Contribution of Noncash Property
The contribution of property to a partnership is generally a tax-free event, designed to facilitate business formation. This section explores how the tax code achieves this deferral through a system of interlocking basis rules.
Interactive Basis Simulation (IRC § 721, 722, 723)
Click the 'Contribute Property' button below to visualize how basis is transferred from a partner to the partnership. This demonstrates the core concepts of "substituted basis" for the partner and "carryover basis" for the partnership, which together preserve the built-in gain for future recognition.
Partner
Property Basis
$4,000
Property FMV
$10,000
Partnership
Partner's Outside Basis
?
Partnership's Inside Basis
?
Nonliquidating Distribution
Distributions of property are also generally tax-free. However, the basis rules can create disparities. The optional IRC § 754 election is a critical tool for correcting these issues and providing a tax benefit to the remaining partners.
The § 754 Election Simulator
This simulation shows what happens when a partnership distributes an asset with a high inside basis ($500) to a partner who has a low outside basis ($100). Toggle the § 754 election switch to see how it prevents tax basis from "disappearing" and instead preserves it for the benefit of the remaining partners via a § 734(b) adjustment.
Partner Receives Asset
Partner's Outside Basis Before: $100
Partnership's Inside Basis of Asset: $500
Due to the basis limitation rule of § 732, the partner's basis in the asset is stepped down to their outside basis.
Partner's Basis in Asset After
$100
Impact on Partnership
Asset Basis Lost in Step-Down: $400
What happens to this $400 of "disappeared" basis?
Basis Adjustment to Remaining Assets
$0
Key Takeaway: With a § 754 election, the $400 of basis that was stepped down at the partner level is added back to the partnership's remaining assets. This provides a direct tax benefit to the other partners through future increased depreciation deductions or reduced gain on sale.
Sale of a Partnership Interest
The sale of a partnership interest is a hybrid transaction, treated as the sale of a single capital asset (§ 741) but with a "look-through" for ordinary income items (§ 751). For the buyer, the § 754 election is critical to align their purchase price with the basis of the underlying assets.
Interactive § 754 Election ROI Calculator
This tool demonstrates the powerful tax benefit of a § 743(b) basis adjustment for the buyer of a partnership interest. Use the sliders to change the transaction variables and see how the § 754 election dramatically increases depreciation deductions and reduces the buyer's taxable gain on a future asset sale.
Note: The sale gain attributable to "Hot Assets" like depreciation recapture would be taxed as ordinary income under § 751.
