Cost Basis of Business and Partnership Interests: Tax Rules

The cost basis of a business or partnership interest is your running tax investment in the entity, and it determines whether cash coming out is a tax-free return of your own money or a taxable event. It starts with what you pay or contribute to acquire the interest, then moves up and down each year as the business earns income, distributes cash, takes on debt, and generates losses. Get the number wrong and you either overpay tax on distributions that should be tax-free or claim losses the IRS will disallow.

How Your Basis Starts

The starting number depends on how you acquired the interest.

Cash or property contribution to a partnership. If you contribute cash, your initial basis equals the cash. If you contribute property, your basis equals the property’s adjusted tax basis in your hands at the time of the contribution, not its current fair market value.¹ Hand over equipment worth $50,000 on the open market but carrying an adjusted tax basis of $30,000, and your starting partnership basis is $30,000. The lower figure prevents a gain at contribution and carries the asset’s tax history into the partnership.

Interest received for services. The fair market value of the interest counts as ordinary compensation income on your personal return, and that reported amount becomes your starting basis. If the interest vests over time, you generally don’t recognize income until it vests, unless you file a Section 83(b) election within 30 days of receipt to lock in the current (usually lower) value upfront.

Buying an interest from another partner. Your basis is your cost, which includes the cash or property paid to the seller plus your assumed share of partnership liabilities.²³ Your outside basis (what you paid) may not match your share of the partnership’s inside basis in its underlying assets. A Section 754 election by the partnership triggers a special basis adjustment that aligns the two for you as the incoming partner.⁴

Gifted interest. You generally take the donor’s basis. This carryover basis means the built-in gain or loss transfers to you along with the interest.⁵ If the donor’s basis exceeds fair market value at the time of the gift and you later sell at a loss, your basis for calculating that loss is capped at the fair market value on the gift date.

Inherited interest. The basis resets to fair market value on the date of the decedent’s death.⁶ If the decedent’s original basis was $40,000 and the interest was worth $250,000 at death, the heir’s basis starts at $250,000. That step-up erases the deferred tax that accumulated during the decedent’s lifetime.

What Increases Your Basis Each Year

Your basis rises by your share of the partnership’s taxable income, whether or not a dollar is distributed to you. It also rises by your share of tax-exempt income, such as interest from municipal bonds.⁷ Adding tax-exempt income to basis keeps those earnings tax-free when the cash eventually comes out. Additional capital contributions raise basis, and so does any increase in your share of partnership liabilities.⁸ The logic is consistent: each time after-tax earnings accumulate inside the partnership, your basis moves up so you aren’t taxed a second time when the money is withdrawn.

What Decreases Your Basis

Distributions of cash and property reduce your basis, as do your share of partnership losses and non-deductible expenses that aren’t charged to capital.⁹ A decrease in your share of partnership liabilities is treated as a cash distribution, which can catch partners off guard when the business refinances or pays down debt.⁸

Basis can never drop below zero. When a cash distribution exceeds basis, the excess is taxed as capital gain from the sale of your partnership interest.¹⁰ Losses work differently. If your share of losses exceeds your remaining basis, the excess isn’t taxed but it isn’t deductible either. Those disallowed losses are suspended and carry forward until basis rises enough to absorb them.¹¹

Order matters. Increases from income are applied first, then decreases for distributions, then decreases for losses. That sequence often creates enough room in the year to absorb distributions and losses that would otherwise exceed basis.

How Partnership Liabilities Shape Basis

Partnership liabilities are one of the biggest structural advantages partnerships have over other entity types. When the partnership borrows, your share of the debt increases your basis as though you contributed additional cash.⁸ You can claim deductions for losses financed by borrowed money even if you never put additional personal funds into the business.

How the debt gets allocated depends on the type. Recourse debt, where one or more partners bear personal economic risk if the partnership can’t pay, is allocated to the partners who carry that risk. Nonrecourse debt, typically secured only by partnership property with no partner personally on the hook, is generally shared based on profit-sharing percentages. For real estate partnerships, borrowing that meets the definition of qualified nonrecourse financing gets special treatment: partners are considered at risk for their share despite no one being personally liable.¹²

When the partnership pays down debt, each partner’s share of liabilities drops, and that reduction is a deemed cash distribution. If it exceeds your basis, you owe tax on the excess just as if you’d received actual cash. This is where leveraged partnerships create unpleasant surprises, particularly during refinancings or partner departures that shift how liabilities are allocated.

S-Corporation Basis: The Key Differences

If you own shares in an S corporation rather than a partnership interest, the framework is similar in concept but different in critical details. Your stock basis starts with whatever you paid for your shares and then adjusts annually: up for your share of income and additional contributions, down for distributions, losses, and non-deductible expenses.¹³

The critical difference is debt. In a partnership, your share of entity-level borrowing increases your basis. In an S corporation, it does not. The only way to get debt basis as an S-corporation shareholder is to personally lend money to the corporation out of your own pocket. Guaranteeing a bank loan the corporation takes out does not count.¹⁴ This is the single most common source of unexpected loss disallowances for S-corporation owners.

Even when you have debt basis from a personal loan, it only helps with deducting losses that exceed your stock basis. Debt basis cannot make a non-dividend distribution tax-free; distributions look solely at stock basis.¹⁴ If the S corporation later repays a loan on which your debt basis was reduced by losses, part or all of the repayment is taxable income to you.

The IRS requires shareholders to file Form 7203 when claiming a share of aggregate losses, receiving non-dividend distributions, disposing of stock, or receiving loan repayments.¹⁵ Even in years when filing isn’t mandatory, completing and keeping the form keeps your basis tracking consistent.

Basis Alone Doesn’t Guarantee a Deduction

Having enough basis to absorb a loss is necessary but not always sufficient. Two additional rule sets can block the deduction even when your basis is positive.

At-Risk Limitations

The at-risk rules limit deductible losses to the amount you have personally at risk in the activity, which generally means cash and property you contributed plus amounts you borrowed and are personally liable to repay.¹⁶ Amounts protected against loss through nonrecourse financing, guarantees, or stop-loss arrangements are excluded. Your tax basis can therefore be higher than your at-risk amount, particularly in partnerships where nonrecourse debt inflates basis. Losses blocked by the at-risk rules carry forward to the next year.

Passive Activity Limitations

Even if a loss passes the basis test and the at-risk test, passive activity rules can still block the deduction. A passive activity is any trade or business in which you don’t materially participate, and most rental activities are automatically classified as passive regardless of involvement.¹⁷ Passive losses can only offset passive income, not wages or portfolio income. Limited partners face an added hurdle: their interest is treated as passive by default, making material participation hard to establish. Suspended passive losses stack up until you generate passive income or dispose of your entire interest in the activity.

The three limitations apply in sequence: basis first, then at-risk, then passive activity. A loss must clear all three before it hits your return. Knowing which layer is blocking a deduction matters because the fix for each one is different. Basis is restored with contributions or income; the at-risk amount grows with personal liability or additional cash; passive losses unlock with passive income or a qualifying disposition.

When You Sell Your Interest

Basis is ultimately the number that determines how much tax you owe on exit. Your gain or loss equals the amount you realize minus your adjusted basis at the time. The amount realized includes cash and property from the buyer plus any reduction in your share of partnership liabilities, because that deemed distribution is treated as additional sales proceeds.³ Sell your entire interest and your share of liabilities drops to zero, so the full amount of your former liability share is added to your sale price for tax purposes.

Most of the gain on selling a partnership interest is capital gain, but not all of it. Any portion attributable to the partnership’s unrealized receivables or inventory items is recharacterized as ordinary income.¹⁸ Unrealized receivables include not only unpaid invoices but also depreciation recapture lurking in the partnership’s assets. These “hot assets” prevent partners from converting ordinary income into capital gain by selling their interest instead of waiting for the partnership to sell the underlying assets. The partnership or its tax advisor typically provides the numbers needed to split the sale price between capital and ordinary components.

Tax Basis Is Not Your Capital Account

One of the most common points of confusion is the difference between your tax basis and the capital account balance reported on your Schedule K-1. They are not the same number, and the IRS instructions say explicitly that the K-1 capital account cannot be used to figure your adjusted basis.¹⁹

Your capital account represents your equity in the partnership’s net assets and can go negative. Your outside basis includes your share of partnership liabilities on top of your capital account, and it can never fall below zero.²⁰ A rough formula: outside basis equals your tax basis capital account, plus your share of partnership liabilities, plus any special basis adjustments from a Section 754 election. The K-1 is a starting point, but it leaves out the liability piece and may not reflect every adjustment that affects your actual basis.

Records You Need to Keep

The IRS does not track your basis for you. That responsibility falls entirely on the owner, and reconstructing a basis history years after the fact is expensive and sometimes impossible. The Schedule K-1 you receive each year is the core document for tracking annual adjustments, but you need to do work beyond what the K-1 reports.¹⁹

Beyond K-1s, keep your original purchase agreement or closing statement proving initial acquisition cost, records of every additional capital contribution, documentation of all distributions, and records showing your share of partnership liabilities (recourse and nonrecourse) at year-end. If the partnership made a Section 754 election, keep the supporting calculations. For S-corporation shareholders, Form 7203 serves as both a reporting requirement and a running basis worksheet.¹⁵ The owners who get into trouble are the ones who didn’t keep these records during the quiet years, then scramble to reconstruct everything for a sale or an audit.

1
Office of the Law Revision Counsel. 26 USC 722 – Basis of Contributing Partners Interest
2
Office of the Law Revision Counsel. 26 USC 742 – Basis of Transferee Partners Interest
3
Internal Revenue Service. Sale of a Partnership Interest
4
Office of the Law Revision Counsel. 26 USC 743 – Special Rules Where Section 754 Election or Substantial Built-In Loss
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Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust
6
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired from a Decedent
7
Internal Revenue Service. Publication 541 – Partnerships
8
Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities
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Office of the Law Revision Counsel. 26 USC 705 – Determination of Basis of Partners Interest
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Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution
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Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share
12
eCFR. 26 CFR 1.465-27 – Qualified Nonrecourse Financing
13
Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders
14
Internal Revenue Service. S Corporation Stock and Debt Basis
15
Internal Revenue Service. Instructions for Form 7203 – S Corporation Shareholder Stock and Debt Basis Limitations
16
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
17
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
18
Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items
19
Internal Revenue Service. Partners Instructions for Schedule K-1 Form 1065
20
Internal Revenue Service. Partners Outside Basis