Decisions — The basis of the matter

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Your basis in any partnership is the amount you have invested, and that’s especially true for tax law. As a general rule, your ability to claim losses and other deductions as a partner depends on your basis in the partnership.

In T.C. Memo. 2017-159 (Kohn), the taxpayer became a partner in a law firm on January 1, 1988. The partnership dissolved in 1989, but winding up the partnership’s business by collecting accounts receivable and settling pending lawsuits continued into 1992. During that time, the partnership filed Forms 1065, U.S. Partnership Return of Income, and Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., reflecting income and tax items. The taxpayer received a Schedule K-1 for each year from 1988 through 1991.

Items reported on Schedule K-1 included income from cancellation of the partnership’s debts. The taxpayer did not report this income on his individual income tax return.

The IRS said the taxpayer had to include in income his distributive share of the partnership’s discharge of indebtedness income. The court agreed.

Next, the IRS said the taxpayer had to include in income the $123,045 deemed distribution of the partnership liabilities allocated to him on his 1990 Schedule K-1.

The IRS also said that the deemed distribution reduced the taxpayer’s adjusted basis in his partnership interest to zero and triggered a $31,596 capital gain that he had to include in income.

Finally, the IRS said that because the taxpayer had no remaining basis in his partnership interest, he could not take the loss shown on his 1991 Schedule K-1.

 

Here’s the applicable tax law.

From internal revenue code section 702(a). A partner must recognize her distributive share of partnership income or loss; such recognition is reflected in the partner’s adjusted basis in her partnership interest pursuant to section 705(a).

From internal revenue code section 704(d). A partner can deduct her distributive share of partnership loss to the extent of her adjusted basis in her partnership interest at the end of the partnership year in which the loss occurred.

From internal revenue code section 752(a). Provides that any increase in a partner’s share in partnership liabilities shall be treated as a contribution of money by the partner to the partnership, increasing the partner’s basis in her partnership interest.

From internal revenue code section 731(a). Any decrease in the partner’s share of the partnership liabilities is treated as a distribution of money by the partnership to the partner under section 752(b) and results in the recognition of capital gain to the extent the distribution exceeds the partner’s adjusted basis in her partnership interest.

 

Here are the dollar amounts as reported on the taxpayer’s Schedule K-1.

Note: 1988 was the first year the taxpayer was a partner; his basis begins at zero for that year.

NOTE: The taxpayer’s Schedule K-1 for 1990 reports his share of partnership liabilities as $123,045 (as shown above) but the partnership’s tax return showed his share of the partnership liabilities to be $122,224. The record does not explain this discrepancy.

 

 

Based on the above information, do you calculate that the taxpayer’s final basis in the partnership will allow him to claim the $30,287 loss on his 1991 federal income tax return?

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THE DECISION

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Click here for a graphic of how the court calculated the taxpayer’s basis.

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Right answer!

We calculate that the taxpayer had an adjusted basis of $94,641 in his partnership interest immediately before the $122,224 deemed distribution as a result of the elimination of his share of partnership liabilities in that amount.

Since the deemed distribution exceeded his adjusted basis in his partnership interest by $27,583, he was required to recognize capital gain in that amount for 1991 under section 705(a).

We accordingly sustain the IRS’s determination to that effect.

Having determined that the taxpayer had no remaining basis in his partnership interest as of the end of 1991, we accordingly conclude that he was not entitled to deduct his $30,287 distributive share of partnership losses for that year and we sustain the IRS’s determination to that effect.

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