Determining Basis in Pass-Through Entities (§ 704(d), § 1366(d))

Basis is the foundation of pass-through taxation and one of the most neglected items in practice, usually until an audit or a sale forces the issue. It governs loss deductibility, the character of distributions, and gain on disposition.

Why basis matters

Three rules: under § 704(d) (partnerships) and § 1366(d) (S corporations), losses are deductible only to the extent of basis, with the excess suspended; distributions in excess of basis generally produce capital gain; and gain or loss on a disposition depends on basis.

Partnership basis

A partner's outside basis starts with contributions and is adjusted annually. Critically, it includes the partner's share of partnership liabilities under § 752, the single biggest difference from S corp basis. It increases for additional contributions, the partner's share of income (including tax-exempt income), and increases in the share of liabilities; it decreases (not below zero) for distributions, the share of losses and nondeductible expenses, and decreases in the share of liabilities.

S corporation basis

S corporation shareholders track two bases, stock and debt, and get no basis for entity-level debt. Debt basis arises only for loans the shareholder makes directly to the corporation. A personal guarantee of a bank loan creates no basis, it is not an economic outlay, whereas a partner would get basis for a share of the same liability. Stock basis adjusts in order each year: (1) income items, (2) distributions, (3) nondeductible expenses, (4) deductible losses.

Ordering and restoration

Where both stock and debt basis have been reduced by losses, future income restores debt basis before stock basis. Missing this ordering misstates the deductible loss and the amount at risk.