Deductible Losses Cannot Exceed Your Partnership Basis
Your deductible share of partnership losses may not exceed the “adjusted basis” in your partnership interest. If your share of the loss exceeds your basis [essentially your net investment-to-date, plus your share of partnership earnings (or minus your share of partnership losses), minus your withdrawals from the partnership], the excess loss amount may not be deducted until you have additional partnership earnings or make additional capital contributions sufficient to cover the excess loss (in the subsequent year(s)). A partner will also have basis for loans made to the partnership for which he or she is personally liable.
Jim is a 25% partner in the PJQ Partnership. In Year 1, he invests $5,000 for his partnership interest. His share of the partnership loss in Year 1 is $2,500 and he withdrew $1,000 from the partnership in Year 1 for personal expenses (this is considered a “distribution” to Jim). His adjusted basis at the end of Year 1 would be $1,500 ($5,000-$2,500-$1,000). Since he still has a positive adjusted basis at the end of Year 1, he would be allowed to deduct the full $2,500 loss on his personal return (taken from the Form 1065 K-1 he receives from the partnership).
In Year 2, Jim is still a 25% partner. He adds an additional $1,000 to his capital investment account during the year and makes no withdrawals. At the end of Year 2, Jim’s share of the partnership loss is $3,000. At the end of Year 1, Jim had adjusted basis of $1,500 (which carried forward to the beginning of Year 2) plus he added $1,000 to his capital investment, giving him an adjusted basis of $2,500 before he deducts his share of the Year 2 loss of $3,000. Since his share of the loss exceeds his adjusted basis by $500 ($2,500-$3,000), he can only deduct the amount of the loss that brings his basis down to zero, or $2,500, on his personal return for Year 2. The remaining $500 loss is disallowed for the current year and carried forward to subsequent tax years until Jim’s basis has been restored (by additional capital contributions and/or his share of partnership profits) to cover the loss.
The above example represents the fundamental changes in a partner’s interest in a partnership. There will be other adjustments to each partner’s basis depending on the activities of the partnership and the activities of each partner during the year.
It is absolutely essential that each partner keep track of his or her basis adjustments each year, beginning in Year 1, and until the partnership is either dissolved or the partner terminates his or her interest in the partnership. The burden is on the partner (“taxpayer”) to substantiate his or her basis at the end of each year that he or she is active in the partnership (your documented partner basis history). If your return is selected for examination by the IRS and you have deducted partnership losses, you WILL be asked for your basis calculation history to substantiate the loss.
Usually, if you are invested in a partnership, you will have retained a competent tax advisor who will prepare each year’s basis documentation and who will also maintain a complete history of your investment in the partnership. This history is also very important if you wish to terminate your interest in an on-going partnership or when the partnership is dissolved.
It was my experience, as an IRS auditor, that well over 50% of “small” business partnership (defined as less than $10 million in assets) investors had either no documentation or incomplete documentation regarding their basis. Without this substantiation [including very credible (and expensive) reconstructions], partner losses taken on the examined personal returns were disallowed.
Best advice: track your partnership basis from day one until you leave the partnership or it dissolves.