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One of the primary reasons why computation of a partner’s interest in a partnership and its assets often confuses partners and their advisers alike is that two different, contemporaneously operating measurements exist to value the interest.

Specifically, a partner in a partnership (or a member of a limited liability company treated as a partnership for tax purpose) has both (1) an “outside basis,” measuring the adjusted basis of the partnership interest he holds, and (2) a “capital account,” reflecting his equity investment in the partnership.[1]

A partner’s capital account is substantially different from his outside basis in the partnership interest, and the two concepts should not be confused.  The following chart summarizes the principal similarities and differences between a partner’s outside basis and capital account:

Outside Basis Capital Account
Contributions to Partnership Increase outside basis. Increase capital account.
Distributions Decrease outside basis. Decrease capital account.
Distributive Share of Income and Loss Respectively increase and decrease outside basis. Respectively increase and decrease capital account.
Book Gains;

Book Losses

Adjustments to book value of partnership property do not affect a partner’s outside basis.  For example, for purposes of computing the outside basis of a partner contributing property to a partnership, the partner’s outside basis is increased by his basis in the contributed property regardless of its actual value. A partner’s capital account is often increased or decreased by adjustments to book value of partnership property.   For example, for purposes of computing the capital account of a partner contributing property to a partnership, the initial book value of contributed property must be its fair market value at the time of contribution, regardless of whether this value differs from the basis of the property.
Partnership Liabilities Under Section 752of the Internal Revenue Code, any increase or decrease in a partner’s allocable share of partnership liabilities will cause the outside basis of his partnership interest to increase or decrease. A partner’s capital account is not increased or decreased by partnership liabilities.
Negative Basis; Deficit Capital Account A partner is never permitted to have a negative basis in his partnership interest.  Section 704(d) of the Code prohibits partners from claiming deductions in excess of the basis of his partnership interest.  Likewise, Section 731(a)(1) of the Code requires a partner to recognize gain on receipt of money distributions that would otherwise reduce his basis below zero. A partner is permitted to have a negative or deficit capital account, resulting from his distributive share of losses or by distributions.  A capital account deficit typically represents the amount of cash that the partner would be obligated to contribute to the partnership upon liquidation.

[1] In actuality, there are two different kinds of basis in a partnership: outside basis and inside basis.  Inside basis reflects the adjusted basis of assets held by the partnership, but is not discussed in this article.  Similarly, partnerships also usually maintain two different kinds of capital accounts – one that is determined by reference to the financial accounting method used by the partnership, and another that is used for tax allocation purposes and is determined by reference to Section 704(b) of the Internal Revenue Code.  The two types of capital accounts are often referred to as “book capital accounts” and “tax capital accounts.”  Book capital accounts reflect contributed property at its fair market value at the time of contribution, whereas tax capital accounts reflect such property at its tax basis.