Tax is hard. Making money doing taxes for others is even harder.

That's usually the main driver for the mistakes I find on returns I look at for prospects. Most CPAs understand these basic things, like what we're talking about today - Basis, but they're trying to run a business. And quality is very difficult to scale.

So how can you spot check the K1s you get (or prepare) on a partnership return? And what happens if you get it wrong?

Glad you asked. 🤝

Why Basis Matters

Basis in a partnership does two very important things:

1. Determines how much of any loss is usable, and
2. Determines how much of any distribution is taxable

We'll mostly skip past number one today. But just know that without basis in the partnership, your losses are suspended. We'll save the active, passive, at-risk basis rules that drive "how" the loss is categorized for another week.

What I want to dive into today is whether the distributions are taxable by looking at the K-1. 🔍

How to Find Basis on the K-1

For most partners, their tax basis will be = Ending Tax Capital Account + Allocated Liabilities. Seen below on a sample K-1:

Ending "allocated" liabilities are the amount of liabilities that are on the partnership's books (bank debt, etc) that are portioned out between partners.

Recourse liabilities are the liabilities that are guaranteed by that specific partner. Nonrecourse liabilities (including qualified nonrecourse) are the ones that no partner has a guarantee for.

Usually, the sum of these two numbers (tax capital + liabilities) is ≥$0. Meaning, we would not expect to see a negative capital account with no associated liabilities. 🫤

Distributions and Basis

Distributions from a partnership are typically one of a few things:

1. Distributions of Profit (Income, Gain, etc)
2. Return of Capital
3. Debt-financed Distributions

In #1 and #2, you'll end up reducing the Box L Partners Capital Account for the distributions not less than $0.

When you make a debt-financed distribution, the Box L Partners Capital Account may go negative but there is typically a balance in Ending Partner's Share of Liabilities that indicates where that distribution came from. And the two ending amounts, again, should be greater than $0.

And If It's Not ≥$0?

Taxable distributions in excess of basis.

It also may indicate we have bad allocations. 💥 That's because loss allocations - another way partners capital accounts get reduced - follow Economic Risk of Loss. So if another partner has a guarantee on a loan that is financing the losses (i.e. equity is $0 from prior losses or distributions), those losses would be allocated to the partner with the debt guarantee.

In the case where there are (a) no allocated liabilities to a partner, and (b) that partner has a negative capital account, any additional losses allocated to them are (a) probably mis-allocated, and (b) suspended due to basis limitations.

And again, any distributions are taxable in this scenario.

Real Life SNAFU Example

We recently brought on a new client. The K-1s actually had allocated liabilities (yay!) but they were wrong. The tax pro had assumed the bank loans were nonrecourse - but the GP had a personal guarantee on all of it.

So the LPs had been over-allocated losses AND were not picking up taxable distributions in excess of basis.

This actually cost the GP hundreds of thousands of dollars in legitimate losses they should have been allocated - something he ended up fighting with the old CPA with and getting a settlement for.

The worst part is that now the LPs are looking at correct K-1s for the first time and realizing, "oh sh*t, my client owes tax on these distributions?"

The Takeaway

It's a quick check - two spots on the K-1. Ending liabilities allocated + ending partners tax capital. If ending capital is negative, you want to see an amount in the ending liabilities.

Yes, it should be caught by the tax pro. But everyone is liable to make mistakes. Getting educated on how to spot these before it becomes a nightmare to explain to the LPs is the name of the game.

[If you file multiple partnership returns for properties you have raised money for, and want a second opinion - reply to this email. We're onboarding clients over the summer as we grow our practice.]

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