Tax Considerations for Adding a New Partner to Your Business

Adding a new partner in a partnership has several financial and legal implications. 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 bases in your partnership interests are sufficient so that the decrease in your portions of the partnership’s liabilities because of the new partner’s entry won’t reduce your bases to zero.

Two Tax Considerations for Adding New Partners

Although the entry of a new partner appears to be a simple matter, it’s necessary to plan the new person’s entry properly in order to avoid various tax problems. Here are two issues to consider:

Recognizing gains

First, if there’s a change in the partners’ interests in unrealized receivables and substantially appreciated inventory items, 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 not only accounts receivable, but also depreciation recapture and certain other ordinary income items. To avoid gain recognition on those items, they must be allocated to the current partners even after the entry of the new partner.

Built-in gain or loss

Second, the tax code requires that the “built-in gain or loss” on assets 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 basis of the partnership property when 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 current fair market value. This will reduce the amount of depreciation that the current partners can take. 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 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 interest can undergo frequent adjustment. 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 are taxed and the maximum amount of partnership loss you can deduct.

Contact us if you’d like help dealing with these issues or any other issues that may arise with your partnership.

© 2023