Partnership Basis
Your partnership basis in a multi-member LLC that is taxed as a partnership will determine the amount of the deductions and net loss of your LLC that you can use to offset your income earned from other sources. Your LLC will by default be taxed as a partnership unless it elects to be taxed as an S corporation or a C corporation. Shareholder basis of an LLC that elects to be taxed as an S corporation or a C corporation is not discussed in this article.
Calculating Your Partnership Basis
Your partnership basis in an LLC is generally the amount of money that you contribute to the LLC and the adjusted basis of the property that you contribute to the LLC. The adjusted basis of such property is computed at the time when you contribute the property to the LLC. If the property that you contribute to the LLC is encumbered by liabilities that the LLC agrees to assume, then your tax basis in the LLC is reduced to the extent of such liabilities assumed by the LLC. The liabilities so assumed by the LLC is regarded as a distribution to you by the LLC. Conversely, the partnership basis in the LLC of the other members is increased to the extent that they assume the debts on the property that you contribute.
Examples of Calculating Partnership Basis
Let’s say you and some of your friends form an LLC to open a restaurant on Washington Avenue in downtown St. Louis. Many years ago, before the area was rebuilt, you bought a large rundown building on Washington Avenue. You and your friends decide that the location of your building is perfect for a restaurant, and you agree to contribute the building to the LLC in exchange for a 20% ownership interest in the LLC. The fair market value of the building is $20,000 when you contribute it to the LLC (it needs a lot of work) and your adjusted basis in the building is $8,000 when you contribute it to the LLC. You also owe the remaining balance of $4,000 on a mortgage you took out to buy the building, which the LLC agrees to assume. Your partnership basis in the LLC is increased by $4,800, which is your $8,000 adjusted basis in the property less 80% of the $4,000 mortgage assumed by the LLC, or $3,200, which is treated as a distribution to you.
If the facts above are the same, but the remaining balance of the mortgage encumbering the property is $12,000, then your partnership basis in the LLC would be zero after you contribute the property to the LLC, as your $8,000 adjusted basis in the property would be decreased by 80% of the $12,000 mortgage assumed by the LLC, or $9,600, which obviously exceeds the amount of your adjusted basis in the property by $1,600. In fact, this $1,600 would be treated by the IRS as a capital gain distribution to you, on which you would owe taxes. (Your partnership basis in the LLC can never be less than zero.)
Allowed Loss Deduction
If your sole contribution to the LLC was the property according to the facts in the first example, then your initial partnership basis in the LLC would equal $4,800. If the LLC’s net income at the end of year one was a $40,000 loss, then you would be allocated 20% of the loss, or $8,000, assuming that allocations are made by the LLC according to each member’s percentage ownership of the LLC. Assuming that your partnership basis in the LLC at the end of year one is still $4,800, you would only be able to offset your income from other sources in that same year by your partnership basis in the LLC of $4,800, not by the full $8,000 LLC loss allocated to you. (However, you might be able to apply the unused portion of the $8,000 loss in future years.) In the second example, you would not be able to use any of the $8,000 loss allocated to you at the end of the first year as an offset to other income earned by you in that same year, as your partnership basis in the LLC at the end of the first year was zero.
Your Partnership Basis in the LLC v. Your Capital Account Balance
The facts in the above examples can show that the balance of your capital account in the LLC is not always equal to your partnership basis in the LLC. Assuming that the LLC operating agreement does not provide otherwise, your capital account in the LLC in the first example would equal $16,000, which is the $20,000 fair market value of the property when you contributed it to the LLC, less the $4,000 mortgage balance encumbering the property when you contributed it. Your capital account in the second example would equal $8,000, which is the $20,000 fair market value of the contributed property less the $12,000 outstanding mortgage balance. Careful recordkeeping throughout each taxable year is essential to maintaining accurate calculations for each member’s capital account and adjusted partnership basis in the LLC.
Adjusting Your Partnership Basis in the LLC
In reality, your partnership basis in the LLC is likely to change, or adjust, during the course of the taxable year of the LLC. For example, you might contribute additional money or property to the LLC during the taxable year, which could increase your partnership basis in the LLC. Your partnership basis in the LLC will also increase by the amount of taxable income earned by the LLC during the year that is allocated to you according to your distributive share. Your partnership basis in the LLC will decrease, but not to below zero, to the extent that the LLC distributes money to you, and generally to the extent of the basis of property distributed to you by the LLC, along with your distributive share of any income loss of the LLC and certain deductions not applied to calculating the net income of the partnership. (Unlike your partnership basis in the LLC, you can have a negative capital account balance in the LLC.)
Good Recordkeeping is Essential
Good recordkeeping is an important component of successfully managing any business, but it is critical when it comes to determining each member’s initial partnership basis in the LLC and their adjusted partnership basis in the LLC over time. Good recordkeeping will also allow you to accurately distinguish between each member’s capital account balance and each member’s adjusted partnership basis in the LLC. While there are many similarities in the calculation of the capital account and the adjusted partnership basis, they are each governed by different laws and regulations, which can, as shown above, lead to a value for one that is different than the value for the other. Don’t confuse the two. Accurately calculating your partnership basis will help avoid applying too much, or too little, of the income loss of your LLC to your other sources of income and the IRS penalties that can come with such mistakes.
The information provided in this article is general in nature, and it is not intended as legal advice. Your circumstances may be unique, and you should therefore consult knowledgeable legal counsel about how the information and concepts discussed in this article might affect you and your business.
Michael Sewell, MBA, JD has numerous years of high level business experience with multi-billion dollar corporations, and he has practiced law in Missouri since 2005. Michael Sewell is the owner of Sewell Law, which forms limited liability companies and provides advice, litigation and other legal services to businesses owners.
Feel free to contact Michael through www.stlouisllcattorney.com.
Published on March 22, 2015.
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