I think most tax professionals would agree, one of the last phrases you want to hear in regards to a tax return is “I think we have basis issues.” Definitely no bueno. But what exactly is basis anyway, and why is it so important?
Basis is essentially the amount of money that a taxpayer has put into an item whether that item is a physical good, such as a house or piece of equipment, or something less tangible, such as an interest in a partnership or S-corporation. For interests in entities, your basis is increased by income allocated to you from that entity, and is likewise decreased by any losses. Distributions of cash or property also serve as a decrease to your basis. It doesn’t end there either – basis in partnership interests take into account liabilities of the partnership itself that may be allocated to the taxpayer. It even gets so granular to where it can matter whether these liabilities are recourse to the partner, or non-recourse. You can probably see why basis has the potential to be one of the more complex areas of taxation.
We’ve established the basics of what basis is, and that it can in some cases be highly complicated, but why is it so important? Well, without knowing a taxpayer’s basis in a piece of property or interest in an entity, there is no way of knowing when the taxpayer has a taxable event related to that item or interest, or the amount of the taxable event. For example, let’s say you sell a collectible baseball card for $10,000, but you have no idea what you paid for the card. Without that information, there is no way to determine whether you have a gain or loss on the card, or how much either one would be. And according to the IRS, if you don’t know your basis, you must presume it to be zero. And that’s no good at all.
For partnership and S-corporation interests, basis is used more frequently than simply for determining gain or loss on disposition. If you receive distributions of cash or property from an entity, you need to have sufficient basis to support those distributions. Otherwise, you’ll end up with what is known as a distribution in excess of basis, which is taxable as long-term capital gain to the recipient. Likewise, if you are allocated losses from an entity, you need sufficient basis to actually take those losses against other taxable income. And of course, you will want to know your basis when you eventually dispose of your interest, whether that is via sale, stock redemption, or perhaps the investment just goes under.
Tracking basis is one of those things that can be easy to push off until later, because it can be a pain, and you don’t always need to know the correct basis to finish up a tax return. Much like many other slightly annoying tasks in life however, pushing it off until later will oftentimes just compound the problem. As time passes and potentially years go by without keeping accurate basis schedules, records become more difficult to locate, past events are foggier in everyone’s minds, and the next thing you know you’re dealing with a complicated sale of a partnership interest, and you have no idea what the taxpayer’s basis is. That is certainly no bueno. So next time you hear “I think we have basis issues”, tackle it then and there. Future you will be glad you did.
For all of your questions and concerns, contact your Henry+Horne tax professional.
Austin M. Bradley, CPA