BASIS

This page presents rules and advice on how to complete and file the IRS Form 1065 Tax Return for a Partnership.

I, Karl Loren, started the Vibrant Life General Partnership on January 1, 1998, with its jurisdiction in the State of California and with Karl and Jean as the only General Partners, and with BET as the only "Qualified Partner."

Here is special data about BET the Qualified Partner in the original General Partnership:

The following was generally true, but changed in the paragraph next below: Per the general section on “profit sharing,” BET would be entitled to 98% of the net income allocated to its Membership. However, because BET had a special allocation arrangement in the original General Partnership, BET continues to get zero percent of any net loss while the Founders get 100% of any net loss.
AS described further below, the VL General Partners recognized the problems that could arise from the above language with the strike out and agreed in principle that despite language to the contrary in the General Partnership Agreement, BET would continue to receive 98% of profits AND LOSSES, and would not be required to “make up” any negative capital account.
It was further agreed, even if not put into written form until after the time of agreement, that either the General Partners (Loren and or Bonnie) could start receiving “retirement pay” when they reached 70 years and that such pay could be related to the good will value of their management during the many years when their profit shares were low.
The traditional rule of GENERAL partnerships is that every partner, regardless of percentage of ownership or contribution would be responsible for 100% of any debts of the Company. This traditional and legal rule meant that a wealthy person who contributed a sum of money but was not active in the management would be a great risk in a business failure. He would be in the position of not having any control, but being legally responsible for ALL debts if other partners could not pay. This limited a partnership in its ability to raise money. This difficulty was then overcome by the invention of a “corporation” in which the owners (stockholders) had zero responsibility for the debts of the Company other than their original investment in stock. When people saw the advantages of the “corporate form of organization” but disliked the control of a corporation by government, they invented a “limited partnership” then a Limited Liability Company.
The limited partnership meant that the LIMITED PARTNEERS could not be held responsible for the debts of the Company beyond their original partnership contribution. In order to have the benefit of a limited partnership the government of various states required that a LIMITED partnership had to register it status with the State, and that registration was then a record made public to put a vendor, creditor or investor on notice that even though he was selling something to a partnership, he could not go after certain of the partners who had the status of “limited” in case of the partnership failing to pay its debt to a vendor.
191. However, in return for getting the State’s protection of “limited liability for limited partners” various states were able to control “limited” partnerships in ways they could not control “general” partnerships. In California the State had a law that a Limited Partnership had to pay a minimum tax of $800 per year. This rule violated the traditional structure of a partnership as a “pass-through” entity, where the entity itself did not pay taxes, but the income of the pass-through entity was passed through to the owners and THEY paid any taxes they owned based on their own personal tax situation.
General Partnership: General Partners have equal management rights. Each is personally (jointly and severally) liable for all Partnership debts and obligations.
Limited Partnership: At least one Partner is a General Partner who is the manager and is personally liable for all Partnership debts and obligations. Limited Partners have no liability for Partnership obligations but cannot take part in management of the Partnership. Limited Partnerships have $800 annual California Tax. Source
The California Minimum tax for a Limited Partnership is paid by the General Partner(s).
Loren created the General Partnership Agreement, Bet signed the agreement. This partnership was a General Partnership with BET described as a “Qualified Partner,” thus giving BET most of the status of a “limited partner” in a Limited Partnership, but without the liability for Loren and Bonnie as the only two General Partners to pay $800 per year tax to the State of California.
So, Vibrant Life was actually and in reality, a “General” partnership with written efforts to give one partner, BET the advantages of a “Limited” partnership. Loren and Bonnie trusted BET to NOT try to obligate the partnership, but did not foresee that BET might be obligated for an responsibility to pay debts without the formal protection of registering as a “limited partnership.”
It is understood here that ANY partnership profit shares are taken from “net income” which has had deducted as part of the process to calculate “net income” any profit sharing bonus paid to either the Member Manager or anyone else, and also any deduction for royalty fees paid to the Founders.
The impact of these named deductions so as to arrive at “net income” means that there may not be any net income left subject to “partner profit sharing.”
BET, was named in the original partnership as a “Qualified Partner,” with no vote on any issue and to receive 98% of the net income and zero percent of any net loss (changed as above to 98% of both profits AND losses. BET also has a similar owner’s interest in the LLC.

I prepared and filed the Form 1065 Returns every year until 2008. For that year I had read the instructions for this Form, including the references to Schedule L of the Return. Schedule L is what presents the balance sheet for the Company and I made the mistake of thinking that Schedule L was not required for Companies with assets of less than $1,000,000. After I filed the 2008 Return the IRS wrote to me in 2009, pointing out that the Balance Sheet (Schedule L) was required for any Return where the sales were $250,000 or more. I paid a penalty to the IRS of $800.

I ultimately underestimated the difficulty of preparing the first ever Vibrant Life balance sheet, paid the IRS penalty and resolved to "do it right" for the 2009 tax year.

When I finally started doing the 2009 return I discovered that there were many complexities to partnership tax rules and accounting. I filed the 2009 return on time, but was not confident that it was correct. See PDF document sent to the IRS with the Form 1065.

The problem I "knew" I had was the lack of understanding of the phrase "adjusted basis," and I resolved to study the use of that term.

Here, for instance is the result of a search engine search on the term "adjusted basis."

About 9,940,000 results (0.14 seconds)

Search Results

Adjusted basis - Wikipedia, the free encyclopedia

In tax accounting, adjusted basis is the net cost of an asset after adjusting for various tax-related items. Adjusted basis is one of two variables in the ...
en.wikipedia.org/wiki/Adjusted_basis - Cached - Similar

Adjusted Basis Definition

Adjusted Basis Definition - Definition of Adjusted Basis Definition on Investopedia - The proportionate value of an asset or security that reflects any ...
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Adjusted Basis Definition - Tax Terms A-Z - About.com

Definition of "Adjusted Basis": the net cost of an asset after adjusting for various tax-related items.
taxes.about.com/od/taxglossary/g/Adjusted_Basis.htm - Cached - Similar

Adjusted basis Glossary Definition: Taxes - MSN Money

To determine your adjusted basis for an asset, start with the original cost. Add your cost of improvements and assessments to the asset, and subtract ...
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Publication 17 (2009), Your Federal Income Tax

Your original basis in property is adjusted (increased or decreased) by certain events. For example, if you make improvements to the property, increase your ...
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adjusted basis legal definition of adjusted basis. adjusted basis ...

adjusted basis n. in accounting, the original cost of an asset adjusted for costs of improvements, depreciation, damage and other events which may have ...
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adjusted basis Definition

adjusted basis - definition of adjusted basis - The base price of an asset or security that reflects any deductions taken on or improvements to the asset or ...
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Federal Income Tax - What is adjusted basis?

For example, if you purchased an antique for $500, your basis in that piece of property is $500, even if it is now worth $10000. Adjusted basis is ...
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Adjusted basis

Measures performance on a risk-adjusted basis. Calculated as the economic return divided by economic capital. RAROC helps determine if a company has the ...
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adjusted basis financial definition of adjusted basis. adjusted ...

Price from which to calculate and derive capital gains or losses upon sale of an asset. Account actions such as any stock splits that have occurred since ...
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Search on August 19, 2010

This web page describes the research into tax laws and regulations, particularly for the partnership form of organization. This page is lengthy and detailed. It is my own advice to myself so that I can prepare the 2010 Return properly and leave here and referenced from here all the advice for another to prepare future Vibrant Life tax returns.

Since "adjusted basis" is a term at the center of the issue, HERE is a link to an official IRS explanation of it. Here is a brief quote from page one of it:

Basis is the amount of your investment in property
for tax purposes. Use the basis of property
to figure depreciation, amortization, depletion,
and casualty losses. Also use it to figure gain or
loss on the sale or other disposition of property.
You must keep accurate records of all items that
affect the basis of property so you can make
these computations.

Much of the value of this page lies in the references to definitions, including special legal or tax definitions.

Just below is a link to Dictionary.com Premium service for "regular" definitions in a good premium web service. In fact if you enter a term rather than a word, this look-up source will usually find the term in a specialized dictionary (such as "financial terms").

Here is a form you can use to look up any word of interest to you:

If you search for the dictionary definition of "basis," you will find the following:

BASIS

ba·sis [bey-sis] Show IPA
–noun, plural -ses [-seez] Show IPA.

the bottom or base of anything; the part on which
something stands or rests.

anything upon which something is based; fundamental
principle; groundwork.

the principal constituent; fundamental ingredient.

a basic fact, amount, standard, etc., used in making
computations, reaching conclusions, or the like: The nurse is paid on an hourly basis. He was chosen on the basis of his college grades.

Mathematics. a set of linearly independent elements of a given vector space having the property that every element of the space can be written as a linear combination of the elements of the set.

Origin:
1525–35; < L < Gk básis step, place one stands on, pedestal, equiv. to ba-, base of baínein to walk, step (akin to come) + -sis
-sis; cf. base1

You will find much more using the "Thesaurus" choice.

The partnership form of organizing a business has its "basis" in the United States Constitution.

There is MUCH more to understanding that term as used in partnership accounting.

The Contract Clause appears in the United States Constitution, Article I, section 10, clause 1. Click the image below to jump to Amazon.com for buying the book shown.

It states:

“ No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility. ”

The Contract Clause prohibits states from enacting any law that retroactively impairs contract rights.

The Contract Clause applies only to state legislation, not court decisions.

[Karl Note: The above Wikipedia source seems wrong to me in that the constitution prohibits any State from passing any Bill, or Law that impairs the obligation of contracts and does not mention the concept of "retroactive." Thus, my reading of the original text makes it ALSO impossible for any State to pass any law, retroactive or not, that impairs the right of contract. The "added Wikipedeia "opinion" that perhaps a "court decision" could do this?" My opinion is that Wikipedia is a known liberal source for false data. There is NO language in the US Constitution that allows a "court" to affect the right of contract even if it may happen.] Top

The Framers of the Constitution added this clause in response to the fear that states would continue a practice that had been widespread under the Articles of Confederation—that of granting "private relief." Legislatures would pass bills relieving particular persons (predictably, influential persons) of their obligation to pay their debts. It was this phenomenon that also prompted the framers to make bankruptcy law the province of the federal government. Source of text in red

Here is how the word "basis" relates to partnership accounting.

While the US Constitution seems to protect the right of contract there have been, nonetheless, countless efforts by courts and regulation to "define" the words in a way that, at least, ADDS to the Constitutional language, if not "impair that language."

Obligation of Contracts

“Law” Defined.—The term comprises statutes, constitutional provisions,1944 municipal ordinances,1945 and administrative regulations having the force and operation of statutes.1946 But are judicial decisions within the clause? The abstract principle of the separation of powers, at least until recently, forbade the idea that the courts “make” law and the word “pass” in the above clause seemed to confine it to the formal and acknowledged methods of exercise of the law-making function. Accordingly, the Court has frequently said that the clause does not cover judicial decisions, however erroneous, or whatever their effect on existing contract rights.1947 Nevertheless, there are important exceptions to this rule that are set forth below. (source of above plus more ..._)

What is an Abusive Tax Scheme?

The Abusive Tax Schemes program encompasses violations of the Internal Revenue Code (IRC) and related statutes where multiple flow-through entities are used as an integral part of the taxpayer's scheme to evade taxes. These schemes are characterized by the use of trusts, Limited Liability Companies (LLCs), Limited Liability Partnerships (LLPs), International Business Companies (IBCs), foreign financial accounts, offshore credit/debit cards and other similar instruments. The schemes are usually complex involving multi-layer transactions for the purpose of concealing the true nature and ownership of the taxable income and/or assets. IRS source

Simple language approach to a "partnership."

Lets describe a simple illustrative partnership, "ABC Company." ABC partnership invites persons to contribute to the partnership.

Mr. A contributes $10,000 in cash.

Mr. B contributes his stock of automotive parts and tools. He says he paid $4,000 for all of this, but that because he bought at bargain rates and because some of the parts are hard to find, his contribution is "worth" $10,000.

Mr. C contributes a parcel of land which he paid $6,000 (recorded bill of sale) for and which he now claims is worth $20,000.

Mss. A, B and C each sign the Partnership Agreement in which they have signed their agreement on the values of the contributions of each of the three partners.

	Contribution Value Agreed in Partnership	Possible Other "basis" of Value
Mr. A	$10,000	$10,000
Mr. B	$10,000	$4,000
Mr. C	$20,000	$6,000
Totals	$40,000	$20,000

What is Mr. C actually bought the land from his son who had paid $1,000 for it, then sold it to his father one month later for $6,000? What if Mr. C is the "managing partner" and the other partners are inactive in the business?

What is Mr. A and Mr. B did not know of Mr. C's purchase of the land from his own son?

What if the partnership loses money, liquidates all the assets at 20% of the agreed partnership value except that the original cash is still in the business when if fails and Mr. A claims fraud and claims that Mr. C made the business fail so that Mr. C could liquidate the Company to the great loss for Mr. A?

Who gets what?

What if Mr. A complains that his $10,000 in cash is worth $10,000 but that despite his signature on the Partnership Agreement, including his agreement on the value of the contributions by Mr. B and Mr. C. he now claims that B and C's contributions are worth less than he agreed, that he was defrauded??

However the Partnership Agreement may contain provisions as to how the value of a contribution should be calculated. There are, then, IRS rules and regulations, as well as court cases, which may require some specific treatment method for calculation of the value of a partner's contribution." Per IRS rule: Agreement. The buyer and seller may enter into a written agreement as to the allocation of any consideration or the fair market value (FMV) of any of the assets. This agreement is binding on both parties unless the IRS determines the amounts are not appropriate. IRS Source]

Much water has flowed under the IRS bridge. We now have the IRS term "adjusted basis" and the terms "

Definition: Adjusted Basis is the net cost of an asset after adjusting for various tax-related items.
Adjusted basis is calculated by beginning with an asset's original cost basis, and then making adjustments. Adjusted basis is calculated as follows:

Cost Basis
+ Purchase costs (title & escrow fees, broker commissions, shipping, sales tax, etc.)
+ Improvements (rehabilitation expenses & substantial repairs)
+ Legal fees (to defend or to perfect title to the property, zoning costs, etc.)
+ Selling costs (title & escrow fees, broker commissions, shipping, transfer fees, etc.)
- Accumulated depreciation, depletion, or amortization
- Casualty or theft Loss
- Other decreases to basis
= Adjusted Basis

Top
Adjusted basis is crucial for calculating capital gains and ordinary gains when an asset is sold.
A complete list of adjustments which increase or decrease basis is found in IRS Publication 551, Basis of Assets. (Source)

In this illustrative example, Mr. A claims that Mr. C's value for the land SHOULD be $1,000 which his son paid, and that Mr. B's contribution of tools and parts is really worth only $4,000, not the $10,000 he claimed.

If Mr. A's figures are right, the Company had contributions worth $4,000 from B and C plus $10,000 from A. In other words A contributed $10,000 of the "real" value of $15,000, or 66%. Even if A accepts the business failure, he claims that he should get at least 66% of what is left.

He even claims that because of the fraud he should get ALL of his money back plus more.

Since the partnership is a "contract" it is guaranteed under the US Constitution not to be "impaired" by any State.

Wouldn't that include a "State Court" (Judges appointed by the State)?

Shouldn't Mr. C get his share of the liquidated value based on his $20,000 agreed value, or some 50% of the liquidated value of the assets, including 50% of Mr. A's cash?

While this example may be overly simple, there were hundreds of such cases brought before various State Courts with all sorts of decisions and appeals.

The IRS regulations have been created by the IRS to prevent what the IRS and some public saw as inequities in the treatments or, at least inconsistencies.

Now I want to jump to basics on partnership accounting:

Asset contributions to partnerships

When a partnership is formed or a partner is added and contributes assets other than cash, the partnership establishes the net realizable or fair market value for the assets.

Karl Note: [Actually the "value" of a contribution is a subject of agreement among the partners and the new partner. Theoretically "value" is subject ONLY to that agreement, but some convention or "politically correct considerations" may intrude.

A common method is to use the "fair market value" of a non-cash contribution.

For example, if the Walking Partners company adds a partner who contributes accounts receivable and equipment from an existing business, the partnership evaluates the collectibility of the accounts receivable and records them at their net realizable value. An existing valuation reserve account (usually called allowance for doubtful accounts) would not be transferred to the partnership as the partnership would establish its own reserve account. Similarly, any existing accumulated depreciation accounts are not assumed by the partnership. The partnership establishes and records the equipment at its current fair market value and then begins depreciating the equipment over its useful life to the partnership.

Income allocations

The partnership agreement should include how the net income or loss will be allocated to the partners. If the agreement is silent, the net income or loss is allocated equally to all partners. As partners are the owners of the business, they do not receive a salary but each has the right to withdraw assets up to the level of his/her capital account balance.

Karl Note: [Generally the Partnership Agreement will include language as to whether or not a partner is allowed to withdraw cash or other items and how that is handled. This web source is not "wrong," it is just incomplete.]

Some partnership agreements refer to salaries or salary allowances for partners and interest on investment. These are not expenses of the business, they are part of the formula for splitting net income. Many partners use the components of the formula for splitting net income or loss to determine how much they will withdraw in cash from the business during the year, in anticipation of their share of net income. If the partnership uses the accrual basis of accounting, the partners pay federal income taxes on their share of net income, regardless of how much cash they actually withdraw from the partnership during the year.

Karl Note: [Actually, whether the partnership uses the accrual of the cash method of accounting, income, whenever and however recognized by the partnership, creates a tax liability for the partners, whether cash is paid to them or not.]

Once net income is allocated to the partners, it is transferred to the individual partners' capital accounts through closing entries. For example, assume Dee's Consultants, Inc., a partnership, earned $60,000 and their agreement is that all profits are shared equally. Each of the three partners would be allocated $20,000 ($60,000 ÷ 3). The journal entry to record this allocation of net income would be:

.

General Journal

Date

Account Title and Description

Ref.

Debit

Credit

20X0

Dec.31

Income Summary

60,000

Dee, Capital

20,000

Sue, Capital

20,000

Jeanette, Capital

20,000

Transfer net income to partners' capital accounts

Karl Note: [Actually the formal partnership accounting usually recognizes more than one "capital" account for a partner, such as is shown immediately below in green.]

Partnerships that use the most usual method of keeping track of the accounting records for the partner's interests will usually have several different "capital accounts:"

The first would be "1. Capital Account: Partner's Original Contribution."

Another could be "2. Capital Account: Partner's Additional Contribution."