**Partnership Liabilities & Basis Rules

Partnership liabilities significantly influence a partner's tax position. They affect a partner's basis in their partnership interest, which in turn determines the amount of losses they can deduct and the gain or loss recognized upon disposition of their interest. There are two primary types of liabilities: recourse and nonrecourse. Understanding the difference is crucial.

• Recourse Liabilities: Liabilities for which a partner (or the partnership itself) is personally liable. If the partnership defaults, creditors can seek repayment from the partners personally. These are allocated according to the partners' loss sharing ratios.
• Nonrecourse Liabilities: Liabilities for which no partner (or the partnership) is personally liable. The creditor can only look to the assets of the partnership for repayment. These are generally allocated based on the partners' profit sharing ratios and other factors outlined in Section 752 of the Internal Revenue Code. However, there are complex rules that follow for nonrecourse liabilities based on allocations of partnership minimum gain (typically based on the amount of depreciation deductions) and excess nonrecourse liabilities, or as they are referred to in the regulations: "excess nonrecourse liability." Excess nonrecourse liability is allocated in accordance with the partners' profit-sharing ratio.

Recourse liabilities are allocated among partners based on their economic risk of loss. This means the allocation is determined by how the partners would share the economic burden of the liability if the partnership's assets become worthless. This generally mirrors their loss-sharing ratio.

Example:

• Partnership ABC has two partners, A and B. Partner A has a 60% loss-sharing ratio, and Partner B has a 40% loss-sharing ratio.
• The partnership has a recourse liability of $100,000.
• Partner A's share of the liability is $60,000 (60% x $100,000), and Partner B's share is $40,000 (40% x $100,000).
• Each partner's basis is increased by their respective share of this recourse liability. If A and B had a beginning basis of $0, their basis would increase by $60,000 and $40,000, respectively.
• Losses and distributions reduce a partner's basis, but never below zero. This is generally the goal in most tax planning structures to ensure the tax-payers are able to take the maximum amount of losses allowable. Any distribution that would cause the basis to go below zero is deemed a taxable gain.

Nonrecourse liabilities are allocated in a three-tiered approach outlined in Section 752 Regulations:

1. Partnership Minimum Gain: First allocated to partners based on their share of the partnership minimum gain. This portion is based on the difference between the nonrecourse debt and the adjusted tax basis of the property securing the debt. As depreciation reduces the property's basis, minimum gain increases.
2. Section 704(b) Minimum Gain Chargeback: Then allocated to the partners based on how the partners share the economic burden if the partnership's nonrecourse debt is foreclosed and/or the property is sold for no consideration.
3. Excess Nonrecourse Liabilities: Lastly, the remaining amount is allocated based on the partners' profit-sharing ratios.

Example:

• Partnership XYZ has three partners: X (50% profit), Y (30% profit), and Z (20% profit).
• The partnership owns a building with a basis of $500,000 secured by a nonrecourse debt of $800,000.
• The partnership's minimum gain is $300,000 ($800,000 - $500,000), meaning the difference between the outstanding loan amount and the basis of the property.
• The minimum gain chargeback rules of Section 704(b) are applied to allocate this gain to the partners. Then the "Excess Nonrecourse Liabilities" are allocated amongst the partners based on the profit-sharing ratios.
• Partner X receives $150,000 (50% x $300,000) for minimum gain plus a pro-rata share of the excess nonrecourse liability, Partner Y receives $90,000 (30% x $300,000) for minimum gain plus a pro-rata share of the excess nonrecourse liability, and Partner Z receives $60,000 (20% x $300,000) for minimum gain plus a pro-rata share of the excess nonrecourse liability.

Note: Depreciation deductions and distributions will reduce basis as well, but never below zero. If the basis would go below zero, this triggers a taxable gain in the current year. This is a very complex area. It is vital to understand the basic principles behind the minimum gain and excess nonrecourse liability rules.

A partner's basis is a dynamic figure, constantly changing throughout the year. It's crucial to track these adjustments to ensure accurate tax reporting. Basis starts with the initial contribution, then increases for:

• Contributions of cash or property.
• The partner's share of partnership taxable income.
• The partner's share of partnership tax-exempt income.
• Increases in the partner's share of partnership liabilities.

And it decreases for:

• Distributions of cash or property.
• The partner's share of partnership losses and deductions.
• The partner's share of partnership nondeductible, noncapital expenditures.
• Decreases in the partner's share of partnership liabilities.

Important Considerations:

• Basis cannot go below zero. If a distribution or loss would reduce a partner's basis below zero, the partner recognizes a taxable gain (or excess deduction) equal to the amount that would otherwise reduce the basis below zero.
• The basis is used to determine gain or loss upon the sale or exchange of a partnership interest.
• Detailed records are critical for accurate basis tracking.