Basis in Partnership Interest: Is your word good enough to support a loss deduction?

In Namen v. Commissioner[1], the taxpayer was a podiatrist in private practice. He was one of 6 members of an LLC that operated a surgical center, which closed in 2009. For federal income tax purposes, the LLC was treated as a partnership. The taxpayer claimed a loss on his personal 2009 income tax return from his interest in the LLC, but the IRS denied the deduction on the grounds that the taxpayer lacked inadequate basis in his partnership interest.

The Tax Court provided this background:

Section 704(d) limits the deductibility of a partner’s distributive share of partnership losses. Those losses are deductible only to the extent of the adjusted basis of a partner’s interest in the partnership. Id.; Sennett v. Commissioner, 80 T.C. 825, 830 (1983), aff’d, 752 F.2d 428 (9th Cir. 1985). A partner’s adjusted basis in the partnership is essentially the partner’s contribution to the partnership increased by the partner’s distributive share of partnership income and decreased by all cash distributions and the partner’s distributive share of partnership losses. Sec. 705(a). If a partner’s distributive share of partnership losses is greater than the partner’s available adjusted basis, the excess loss cannot be deducted by the partner for that year but must instead be carried forward until the partner has an adjusted basis sufficient to offset the amount of the loss. See sec. 1.704-1(d)(1), Income Tax Regs.

The taxpayer testified that he made various contributions to the LLC, which would have provided him basis. He also testified that he was personally liable for loans, which provided him basis. However, the taxpayer did not corroborate the testimony with any evidence. And, the taxpayer did not provide any evidence regarding the amount of his distributive share of partnership losses and the extent of any prior adjustments to his basis. As a result, the Tax Court upheld the IRS’s determined (i.e., the taxpayer could not claim the loss on his personal return). The Tax Court stated that “loan agreements and generalized testimony are insufficient to establish basis in a [partnership] interest.”[2]

What could the taxpayer have done?

Proper documentation is key to proving to the IRS that you have basis. Copies of canceled checks or contribution agreements would provide corroboration for initial contributions. Purchase agreements would help support a taxpayer’s initial basis if he purchased his interest from a partner. Schedule K-1s would help demonstrate adjustments to basis after formation.[3] In addition, retirement or redemption of partners might cause complex tax consequences affecting basis, which may require memos and/or analyses prepared by tax advisers. Finally, all of these items should be tallied on a worksheet/spreadsheet of some type. A partner must be able to support his claim for basis as of the date of the claim (i.e., as of the date of the loss, date of sale, date of distribution).

Many taxpayers believe that they can rely on the little section of the Schedule K-1 that shows a summary of partner’s capital accounts. However, this may or may not be correct. And, if the partnership changed, tax return preparers at any point, there is risk that the summary is not accurate. Finally, capital accounts do not necessary correspond to a taxpayer’s basis in his partnership interest, even if the little box “Tax Basis” is checked.

Takeaway

If you want to claim a loss from a partnership interest, you must be able to provide some support for your basis in your partnership interest. Tracking outside basis can be easily overlooked as an annual task and not all tax preparers track basis for their clients. Failure to properly track basis can costs significant sums of money down the road in lost deductions or return of basis on sale of a partnership interest.

Notes

[1] T.C. Memo. 2017-24 (link).

[2] Namen at 7, citing Hargis v. Commissioner, T.C. Memo. 2016-232, at *29-*30.

[3] Arguing against Schedule K-1s (e.g., “I never received the distribution even though it was reported on Schedule K-1”) will likely not be successful, unless there is objective evidence to support the claim.