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Are you a partner of a partnership? Then you'll want to listen up. Your CPA may or may not have mentioned basis schedules to you, but they are something you should probably stop tuning out.
One of the main reasons that partnerships are popular is because of they offer flexibility with allocations of income, losses, gains, deductions, and distributions to its partners. However, just because non-pro rata allocations in partnerships are allowable, this does not guarantee that the IRS will respect them. If that's the case, then the auditor could have free reign to go back and re-allocate prior years' income and losses according to what he or she thinks is appropriate. Sound a little harsh? It could be.
But don't worry: There is a safe harbor where your partnership allocations can find refuge. The regulations promise to keep the IRS off your back as long as your allocations have "substantial economic effect." The first requirement of meeting this safe harbor is that partners must maintain 704(b) capital accounts. 704(b) capital accounts are important; these accounts ensure the underlying economic arrangement of the partners is clearly reflected. They show the liquidation rights of the partners and determine the allocation of income for both book and tax purposes. So how is this tracked? By basis schedules.
It's best to have a basis schedule that tracks both the 704(b) capital accounts and tax basis. What? Now we're asking for two separate schedules? Yes, but hear me out. These schedules can be built simultaneously using prior years' tax returns. The 704(b) and tax capital accounts will differ for reasons like a partner's contribution of appreciated property and the sale of a partnership interest.
Thus, tracking these two separately allows you to determine how to appropriately allocate income in order to meet the safe harbor requirements and can also help you calculate the tax implications of partnership events, including distribution of property, the sale of a partnership interest, and the liquidation of the partnership.
Still not convinced? I see you like to live on the edge. If you prefer to be out of the safe harbor and among the waves and potential storms of the open ocean, you can determine your partnership allocations without meeting the substantial economic effect requirement. However, beware of the risks you are taking for both you and your other partners — the IRS could come back and disregard all previous allocations. The choice is yours.
Partnership taxation is one of the most complex areas of the Internal Revenue Code. There are also endless pages of regulations and case law, which we CPAs love reading (you're welcome). So don't hesitate to reach out to us if you have additional questions.
Still curious to learn more? Our team at Delap is here to answer your questions. Reach out today to start the conversation.