IRS Code 722 defines how a partner determines their initial tax basis in a partnership interest when they contribute property or money to the partnership. This code is fundamental for calculating a partner's capital account and understanding their financial stake for tax purposes.
Understanding IRS Code 722
Specifically, Section 722 of the Internal Revenue Code (26 U.S. Code 722) establishes the starting point for a partner's tax basis in their partnership interest. This basis is crucial because it helps determine several key tax outcomes for the partner, including the amount of partnership losses they can deduct, the tax-free nature of distributions they receive, and the gain or loss recognized when they sell or exchange their partnership interest.
The core principle outlined by Code 722 is that:
- The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b).
Components of Initial Partnership Basis Under Code 722
When a partner contributes assets to a partnership in exchange for an interest, their initial basis is calculated by summing the following:
- Amount of Money Contributed: Any cash directly contributed to the partnership.
- Adjusted Basis of Contributed Property: The contributing partner's adjusted basis in any property (other than money) transferred to the partnership. This is not the fair market value of the property, but rather its tax basis in the hands of the contributing partner immediately before the contribution.
- Gain Recognized (if any): In rare instances, a contributing partner might be required to recognize gain on the contribution of property to a partnership. If such gain is recognized (e.g., due to certain investment company rules or where liabilities assumed by the partnership exceed the contributing partner's basis in the contributed property), that recognized gain increases the partner's initial basis.
Here's a quick summary of the components:
| Component | Description |
|---|---|
| Money Contributed | The exact dollar amount of cash transferred to the partnership. |
| Adjusted Basis of Property | The contributing partner's original cost (plus improvements, minus depreciation) of the non-cash assets. |
| Gain Recognized | Any taxable gain the partner is required to report on the contribution itself. |
Why is Your Partnership Basis Important?
Understanding and accurately tracking your partnership basis is vital for several tax-related reasons:
- Loss Deductibility: A partner can only deduct their share of partnership losses up to their adjusted basis in the partnership interest. Losses exceeding this basis are suspended and can be carried forward indefinitely until the basis increases or the interest is disposed of.
- Tax-Free Distributions: Distributions from a partnership are generally tax-free to the extent of a partner's adjusted basis. Distributions exceeding this basis are typically treated as taxable gain (capital gain).
- Sale or Exchange of Interest: When a partner sells or exchanges their partnership interest, the adjusted basis is subtracted from the sale proceeds to determine the taxable gain or loss.
Practical Application and Examples
Scenario: Alex and Ben decide to form a partnership, "AB Services."
- Alex's Contribution: Alex contributes $10,000 in cash.
- Ben's Contribution: Ben contributes equipment with an adjusted basis of $15,000 (its fair market value is $20,000).
Calculating Initial Basis:
- Alex's Initial Basis: $10,000 (cash contributed) = $10,000
- Ben's Initial Basis: $15,000 (adjusted basis of equipment) = $15,000
In this typical scenario, no gain is recognized on the contribution under IRS Code 721, so the "gain recognized" component of Code 722 is zero. If, however, the partnership assumed liabilities from Ben that exceeded Ben's basis in the equipment, Ben might have to recognize a gain, which would then increase his basis accordingly.
Subsequent Adjustments to Basis
While IRS Code 722 establishes the initial basis, a partner's basis is not static. It is a dynamic figure that is constantly adjusted throughout the life of the partnership. Subsequent adjustments are governed by other sections of the tax code, primarily IRS Code 705 and IRS Code 752:
- Increases to Basis: A partner's basis increases by their share of partnership taxable income, tax-exempt income, and an increase in their share of partnership liabilities.
- Decreases to Basis: A partner's basis decreases by their share of partnership losses, non-deductible expenses (that are not capital expenditures), and a decrease in their share of partnership liabilities, as well as distributions received from the partnership.
These ongoing adjustments ensure that a partner's basis accurately reflects their economic investment and share of the partnership's financial performance.
Key Takeaways
- IRS Code 722 is foundational for partnership taxation, dictating the initial tax basis of a partner's interest upon contribution.
- It ensures that a partner's basis reflects the money and the adjusted basis of property they contribute.
- This basis is critical for determining a partner's ability to deduct losses, receive tax-free distributions, and calculate gain or loss on the disposition of their partnership interest.
- While Code 722 sets the initial basis, other IRS codes govern the continuous adjustments to this basis over time.
