Partnership Taxation

REG loves the outside-basis ordering rule: a partner’s basis is increased by their share of partnership income before you subtract distributions, and the deduction of losses is limited to basis (then at-risk, then passive). The classic MCQ gives a beginning basis, a distributive share, a cash distribution, and a liability change, then asks for ending basis or the deductible loss. The “tell” is that a partner’s share of partnership liabilities is added to outside basis (§752) — students forget this and understate it. A cash distribution exceeding basis triggers capital gain under §731 (not ordinary income, absent §751 “hot assets”).

The trap is conflating partnership and S-corp rules. Unlike an S corp, partnership liabilities give basis to partners, so debt-funded losses can be deductible; an S shareholder gets debt basis only from direct loans to the corporation, not entity-level debt (a mere guarantee doesn’t count). Contributing appreciated property is generally nontaxable under §721 and yields a carryover (substituted) basis, distinct from the cost basis the basis term describes. Remember: income first, then distributions — order matters.