While a shareholder’s basis in his or her corporate stock generally stays unchanged over time (except for S corporations), a partner’s basis in his or her interest can undergo frequent adjustment. It’s very important to keep proper track of your basis because it can have an impact in several areas: gain or loss on the sale of your interest, how partnership distributions to you are taxed, and the maximum amount of partnership loss you can deduct.

Your basis starts off as your cost (if you buy your interest), or as the amount of cash plus the basis of property you contributed (if you get it via partnership contributions). If you get your interest by providing services to the partnership (and your interest is not a mere profits interest), you are taxed on its value and that value becomes your opening basis in the interest.

Once you are a partner, your basis undergoes the following adjustments:

 (1) It’s increased by the share of partnership income or gains (e.g., capital gains) allocated to you. This adjustment takes place as of the last day of the partnership’s tax year. If the partnership has tax-exempt income, your basis increases by your share of this income as well.

 (2) Conversely, your basis is decreased by your share of partnership losses (ordinary or capital). As with the adjustment for income or gains, this adjustment takes place as of the last day of the partnership’s tax year. You aren’t allowed to deduct losses in excess of your basis so your basis cannot be reduced below zero under this rule. (As a general tax principle, your basis in any asset can never go below zero.)

 (3) Your basis in your interest is increased by any cash you contribute to the partnership and by the basis of any property you contribute. This basis adjustment is made when the contribution is made.

 (4) Again, conversely, your basis in your interest is decreased by any cash distributed to you by the partnership and by the basis you get in any property distributed to you. This basis adjustment is made when the distribution occurs. Your basis can’t go below zero under this rule either: if you receive cash in excess of basis you report the excess as taxable gain rather than reducing basis. And if you receive a distribution of property from the partnership, you can’t receive a basis in it greater than the basis you had in your partnership interest. Thus, the basis reduction can never be more than the basis itself.

Effect of liabilities. The partnership liabilities rules can have an impact on your basis in your interest through the contribution/distribution rules discussed above. Under these rules, when your share of partnership debt increases, you are treated as making a cash contribution to the partnership to that extent. On the other hand, when your share of partnership debt decreases you are treated as receiving a cash distribution from the partnership to that extent.

This means whenever the partnership takes out or increases a loan, a cash contribution is considered to have been made by the partners. Under rule (3), above, each partner’s basis in his or her interest will be increased by his or her share of the debt increase. And whenever the partnership pays back all or part of a loan, a cash distribution is considered to have been made to the partners. Under rule (4), above, each partner’s basis in his or her interest will be decreased by his or her share of the debt reduction. A partner’s share of a debt depends on whether the partnership or any partnership is liable (“recourse debt”) or whether there is no such liability (“nonrecourse debt”). Generally, a recourse debt is shared based on the amount that a partner would have to pay to the creditor or contribute to the partnership to satisfy the debt if the property securing the debt became worthless. In the case of nonrecourse debt, the partnership has some flexibility, but such debt is traditionally shared in accordance with the partners’ profit percentages, after taking into account certain required allocations to reflect earlier deductions.

As you can see, depending on partnership activities, the partners’ bases in their interests may have to be adjusted frequently.