According to the Internal Revenue Service, the 2019 tax year saw more than 25 million partners comprising nearly four million tax returns filed by partnerships 2019. With many concerns necessary for navigating the U.S. tax code, including filing annual returns, one important consideration for partnerships and their partners is how to calculate tax liability. To determine how much they profit or lose on their investment, there must be an accurate calculation of adjusted cost basis via outside cost and inside cost basis.
According to the Internal Revenue Code (IRC), one aspect of Section 754 details how the tax basis of partnership assets is handled. When partnerships change, or when there are changes in partnership interest, it helps to rebalance the basis of the business entity's property. This entails defining and calculating both the outside cost basis and the inside cost basis. 
Understanding Outside Cost Basis
Outside cost basis refers to the percentage of interest each partner owns in a partnership. For example, if three partners own a partnership and each partner contributes $200,000, this establishes their outside cost basis. Recording what each initial partner contributes to the partnership is essential to determine their tax basis, including whether they’ve established a loss or gain, and therefore their tax obligations.
Understanding Inside Cost Basis
As the IRC explains it, “Inside basis refers to a partnership's basis in its assets.” One way to look at it is if three partners bought an asset for $600,000, each contributing $200,000 (symbolizing their inside cost basis), their respective inside basis in that particular asset would be $200,000.
When to Consider a Section 754 Election
It’s important to distinguish that partnerships adding or selling partnership interests must consider how such changes impact owners’ tax basis. By making a Section 754 election, partnerships can adjust the cost basis for new partners to provide an accurate accounting of profits (or losses). Assume five partners contributed $200,000 to a partnership and bought an asset for $1 million. A year later, the asset appreciated to $1.3 million. The outside basis is $200,000 (per partner) and the inside basis is $1 million.
Assume the asset appreciates to $1.3 million and one of the original five partners wants to cash out and sell their portion to a new, independent partner for $260,000. The original partner must pay taxes on the appreciation of $60,000 when exiting the partnership. Assume three months later, the asset is sold at the same price of $1.3 million with no Section 754 election. The four original partners are faced with a taxable gain of $60,000 each ($1.3 million selling price Р$1 million inside basis) / 5 partners = $300,000 profit / 5 partners). However, despite the new partner’s outside basis of $260,000, they would face the same $60,000 tax liability.
However, if a partnership chose to elect its partnership to Section 754, the new partner’s tax basis is “stepped up” to $260,000 instead of remaining at the original partner's basis of $200,000. The new partner’s inside cost basis will remain at $200,000, requiring no adjustment. However, the new partner now has an outside basis of $260,000 – the amount the partnership interest was sold for from the original partner to the new partner.
While each business arrangement is unique, for partnerships that see their assets regularly increase in value and experience frequent changes in partners, it could make sense to go with a Section 754 election.
FAQs
As the IRC explains it, “Inside basis refers to a partnership's basis in its assets.” One way to look at it is if three partners bought an asset for $600,000, each contributing $200,000 (symbolizing their inside cost basis), their respective inside basis in that particular asset would be $200,000.
How do you track outside basis in partnership? ›
A partner's outside basis can generally be computed as the partner's capital account plus the partner's share of liabilities. Some examples of the effect on the partner's capital account and outside basis include: Contributions to partnership – Increases capital account and outside basis.
What is an example of a partnership inside and outside basis? ›
Inside basis focuses on individual assets, while outside basis has to do with each partner's interest in the partnership. For example: Partner A contributes $50,000 in cash. Partner B contributes property valued at $50,000 (at the time of the contribution), but the property was originally purchased for only $25,000.
What is the basis of partnership distribution? ›
The basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner's interest shall be an amount equal to the adjusted basis of such partner's interest in the partnership reduced by any money distributed in the same transaction.
What is the difference between inside basis and outside basis S Corp? ›
In tax law the inside basis is the cost basis of an entity (such as a corporation, partnership, or LLC) in its assets. The outside basis is the owners' basis in their interests in the entity.
What is the formula to calculate basis? ›
To calculate your basis, the average cost method takes the cost of all the shares you have purchased and divides it by the number of shares.
What will generally a partner's outside basis in a partnership equal? ›
This template calculates each partner's outside basis in the partnership, which equals the partner's tax basis capital account plus his share of partnership liabilities.
How to calculate basis in an LLC? ›
The basis calculation consists of your financial contributions to the company plus ordinary income and losses minus distributions (like dividends and other payouts). The cost basis is most often calculated using the First In, First Out, or FIFO method.
How do you determine property basis? ›
How Do I Calculate Cost Basis for Real Estate?
- Start with the original investment in the property.
- Add the cost of major improvements.
- Subtract the amount of allowable depreciation and casualty and theft losses.
A partner's adjusted basis in their partnership interest is decreased (but not below zero) by the money and adjusted basis of property distributed to the partner.
The first example below shows an example of the inside basis for a tax investor. This account includes a step up depreciation and income reallocation in the screenshot below. Note in the examples that the balance can be negative — it is not limited by the suspended loss.
What is the difference between inside and outside basis M&A? ›
There are two types of tax basis: inside basis and outside basis. The inside basis is the tax basis that a company has in its assets. The outside basis is the tax basis that a shareholder (which could be corporate entity) has in the shares of a company.
How do you calculate the inside basis of a partnership? ›
To illustrate, consider this example: You contribute $50,000 in cash to a partnership. Your partner contributes land with a fair market value of $50,000 and a tax basis of $10,000. Thus, the total inside basis of the partnership is $100,000, but each partner's outside basis is different.
What adds to partnership basis? ›
The basis of a partner's interest in a partnership ( ¶443) is increased by his or her distributive share of partnership taxable income, the partnership's tax-exempt income, and the excess of partnership deductions for depletion over the basis to the partnership of the depletable property ( Code Sec. 705).
What is the outside basis difference? ›
An outside basis difference is the difference between the carrying amount of an entity's investment (e.g., an investment in a consolidated subsidiary) for financial reporting purposes and the underlying tax basis in that investment (e.g., the tax basis in the subsidiary's stock).
How do you calculate partner's adjusted basis? ›
You can figure the adjusted basis of your partnership interest by adding items that increase your basis and then subtracting items that decrease your basis. Use the Worksheet for Adjusting the Basis of a Partner's Interest in the Partnership to figure the basis of your interest in the partnership.
How do you calculate partnership buy in? ›
Your buy-in price will be a percentage of the total value, usually divided equally among all of the partners. Thus, if there are already four partners, you would be the fifth partner, and the total practice value would be divided by 5 to determine your buy-in amount.
What is the basis for each partner in his partnership interest? ›
As previously stated, outside basis is a partner's basis in his partnership interest. Inside basis is the partnership's basis in its assets. Typically, at the start of the partnership, the sum of each partner's outside basis equals the partnership's inside adjusted tax basis in its assets.
How do you calculate partners capital? ›
A partner's opening capital account balance generally equals the value of his contribution to the partnership – (i.e. cash plus the net value of any contributed property).
