Bringing a new partner into your business is a significant step, and it comes with various financial and legal implications. To illustrate, let’s consider a scenario: you and your partners decide to admit a new partner who will acquire a one-third interest in the partnership through a cash contribution. Assume that your basis in your partnership interests is sufficient so that the decrease in your portions of the partnership’s liabilities due to the new partner’s entry won’t reduce your basis to zero.
More Complex Than It Seems
Although adding a new partner may seem straightforward, it requires careful planning to avoid various tax complications. Here are two critical issues to consider:
- Unrealized Receivables and Substantially Appreciated Inventory Items:
- A change in the partners’ interests in unrealized receivables and substantially appreciated inventory items will be treated as a sale of those items, resulting in the current partners recognizing gain. Unrealized receivables include not only accounts receivable but also depreciation recapture and certain other ordinary income items.
- To avoid gain recognition on these items, they must be allocated to the current partners even after the new partner’s entry.
- Built-In Gain or Loss Allocation:
- The tax code mandates that the “built-in gain or loss” on assets held by the partnership before the new partner was admitted be allocated to the current partners, not to the entering partner. Generally, “built-in gain or loss” is the difference between the fair market value and the basis of the partnership property at the time the new partner is admitted.
- As a result, the new partner must be allocated a portion of the depreciation equal to their share of the depreciable property based on the current fair market value. This allocation reduces the amount of depreciation available to the current partners. Additionally, the built-in gain or loss on the partnership assets must be allocated to the current partners when the partnership assets are sold. This area’s rules are complex, and the partnership may need to adopt special accounting procedures to comply with these requirements.
Follow Your Basis
When adding a partner or making other changes, a partner’s basis in their interest can undergo frequent adjustments. Keeping accurate track of your basis is crucial because it impacts several areas:
- Gain or Loss on the Sale of Your Interest: Your basis affects the calculation of gain or loss when you sell your partnership interest.
- Taxation of Partnership Distributions: Your basis influences how partnership distributions to you are taxed.
- Deductible Partnership Losses: The maximum amount of partnership loss you can deduct depends on your basis.
We Can Help
Navigating the complexities of adding a new partner requires careful planning and expertise. Accavallo & Company, LLC is here to assist you in dealing with these issues and any other matters that may arise in connection with your partnership. Contact us for professional guidance and support to ensure a smooth transition and optimal tax outcomes.
