Adding a new partner in a partnership has several financial and legal implications. For example, let’s say you and your partners are planning to admit a new partner. The new partner will acquire a one-third interest in the partnership by making a cash contribution to it. Let’s further assume that your basis in your partnership interests is sufficient so that the decrease in your portions of the partnership’s liabilities because of the new partner’s entry won’t reduce your basis to zero.
Not as Simple as it Seems
Although adding a new partner appears to be a simple matter, it’s necessary to plan the new person’s entry properly to avoid various tax problems. Here are two issues to consider:
First, suppose there’s a change in the partners’ interests in unrealized receivables and substantially appreciated inventory items. In that case, the change is treated as a sale of those items, with the result that the current partners will recognize gain. For this purpose, unrealized receivables include accounts receivable and depreciation recapture and certain other ordinary income items. To avoid gain recognition on those items, it’s necessary that they be allocated to the current partners even after the entry of the new partner.
Second, the tax code requires that the “built-in gain or loss” on assets that were held by the partnership before the new partner was admitted be allocated to the current partners and not to the entering partner. Generally speaking, “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.
The most important effect of these rules is that the new partner must be allocated a portion of the depreciation equal to his share of the depreciable property based on the current fair market value. This will reduce the amount of depreciation that can be taken by the current partners. The other effect is that the built-in gain or loss on the partnership assets must be allocated to the current partners when partnership assets are sold. The rules that apply here are complex, and the partnership may have to adopt special accounting procedures to cope with the relevant requirements.
Keep Track of Your Basis
When adding a partner or making other changes, a partner’s basis in his or her interest can undergo frequent adjustment. Therefore, it’s imperative to keep proper track of your basis because it can impact 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.
Contact us if you are thinking of adding a new partner or have any other issues with your partnership that you would like to discuss.