Overview

Partnership tax law tracks a partner’s outside basis—the partner’s adjusted tax investment in the partnership—so that distributions, income, losses, and changes in partnership liabilities affect the partner’s tax results. The IRS explains these rules for partnerships and partners in Publication 541 and related guidance (IRS, Partnerships). Follow a simple rule of thumb: distributions reduce outside basis; if a distribution exceeds outside basis, the excess is treated as a taxable gain. (See IRS guidance: https://www.irs.gov/businesses/partnerships.)

Key rules, step by step

  • Starting point: outside basis. A partner’s initial outside basis equals cash and the adjusted basis of property contributed, plus the partner’s share of partnership liabilities (IRC §752).

  • Basis increases. Outside basis increases for: additional cash or property contributed, the partner’s allocated share of taxable partnership income, and increases in the partner’s share of partnership liabilities.

  • Basis decreases. Outside basis decreases for: cash or property distributions, the partner’s allocated share of partnership losses or nondeductible expenses, and reductions in the partner’s share of partnership liabilities.

  • Distributions and tax treatment. Nonliquidating distributions are generally tax-free to the extent they do not exceed a partner’s outside basis; they reduce basis dollar-for-dollar. If a distribution (cash plus the basis in distributed property) exceeds outside basis, the excess is recognized as a capital gain by the partner (IRC §731).

  • Basis of distributed property. When partnership property is distributed, the recipient partner generally takes the partnership’s adjusted basis in the property (not its fair market value) with special ordering and character rules that can affect loss recognition (IRC §732). This preserves the partnership’s built-in gain or loss.

  • Loans and liabilities. A partner’s share of partnership liabilities increases outside basis; conversely, relief from partnership liabilities reduces basis and can trigger gain if the partner gets cash or property that exceeds remaining basis.

Examples

  • Cash distribution within basis: Partner A has outside basis $40,000 and receives $25,000 cash. New outside basis = $15,000; no gain is recognized.

  • Distribution exceeding basis: If Partner A’s outside basis is $20,000 and they receive $30,000 cash, $10,000 is recognized as a capital gain under IRC §731.

  • Property distribution: Partner B receives property with FMV $30,000 but the partnership’s adjusted basis in that property is $12,000. Partner B generally takes basis $12,000 in the distributed property; outside basis is reduced by $12,000 (with complex ordering rules applying).

Why this matters in practice

  • Loss limits and suspended losses: A partner cannot deduct partnership losses that exceed their outside basis. Tracking basis matters if you expect to use allocated losses on your individual return.

  • Unexpected gains: Cash withdrawals and liability shifts can create gain when you least expect it. For example, debt relief or reallocation of loan shares can lower basis and trigger taxable amounts.

Practical tips (from practice)

  1. Keep a rolling basis worksheet. Update it after each K-1, contribution, distribution, and change in partnership debt. Use the Schedule K-1 as the starting document for allocations—see our guide on how to use Schedule K-1 for partnerships and S corporations for help: How to Use Schedule K-1 for Partnerships and S Corporations.

  2. Track partnership liabilities. Note whether liabilities are recourse or nonrecourse because that affects how much your outside basis changes.

  3. Correct mistakes early. If you or your preparer discovers a basis error on a prior return, correct it promptly; see our article on correcting basis and capital gain errors for steps to amend returns and documentation: How to Correct Basis and Capital Gain Errors with an Amended Return.

When to get help

These rules are technical—if distributions, allocated losses, or changing debt levels will meaningfully affect your tax position, consult a CPA or tax attorney. In my practice I’ve seen clients avoid large unexpected tax bills by modeling distributions and debt allocations before year-end.

Authoritative sources

  • IRS, “Partnerships” landing page and Publication 541 (Partnerships): https://www.irs.gov/businesses/partnerships
  • IRC sections 705, 731, 732 (rules on partnership outside basis, distributions, and basis of distributed property)

Professional disclaimer

This article is educational and general in nature and does not constitute tax advice. For personalized tax planning or to resolve a specific dispute with the IRS, consult a qualified CPA or tax attorney familiar with partnership taxation.