More about basis (than you ever wanted to know)
Kevin Crouse follows up on his question about members' basis........
Does the members' basis change when a member withdraws his interest in the partnership?
Does the basis of the stocks the club owns change when a member withdraws his interest in the partnership?
The reason I ask is because when the withdrawing member cashes out, he takes his share of the unrealized gains/losses from the stocks the club owned at the time he cashed out.
This gets a little complicated. I'll try a simple (I hope) example. Suppose you are in a club with only 2 members. You each put in $10,000. You buy a stock for $5,000, and that stock doubles in value. At this point, you have $15,000 in cash, a stock that cost $5,000 that is now worth $10,000. So the total assets of the club are $25,000, and you are worth $12,500 each. Your partner decides to get out, and the partnership pays him $12,500 cash for his interest. He will report a gain on his 1040 of $2,500.
Now, the partnership decides to sell the stock. They realize $10,000. So the partnership has a gain of $5,000 on the stock, which will be allocated to the remaining partners.
Consider what has happened to this point. The outgoing partner has reported a gain of $2,500. The partnership will be reporting a gain of $5,000. This totals $7,500. BUT the only economic gain realized is that the stock went from $5,000 to $10,000 - a gain of $5,000. This gain would be added to the basis of the remaining partners, so the extra $2,500 would be recovered when the remaining partners leave the club, but this could be years down the line.
The IRS does offer a way around this. You can make a 754 election. Under this election, you are entitled to increase the basis of any stock with a built-in gain, when a member who has an appreciated position leaves the club. In plain English, you would increase the basis of the stock by $2,500 when your partner leaves. So then upon selling the stock, the gain would only be $2,500.
No investment club software presently on the market has the capability to deal with a 754 election. bivio does plan to have this capability by the end of the year 2000. It should be noted that a 754 election does not always have favorable results. If the value of the clubs assets have depreciated when a partner leaves, the basis of the remaining stocks will be written down. The best you can say about a 754 election is that the reported gains/losses will always be equal to the economic gains/losses.
My friend and cohort, Jerry Dressel, would take it amiss if I did not mention that the problem can also be solved by distributing stock to the departing member. Suppose that the club had transferred the stock worth $10,000 to the departing member and paid him $2,500 in addition. Then the situation would be that the club has realized no gain or loss. The departing member does not realize any gain or loss until he sells the stock. His basis will be his original basis in the club, less cash received or $7,500. If he were to sell the stock immediately he would again have a gain of $2,500. ($10,000-$7,500).
This is a very brief attempt at explaining a very complicated subject. There could have been a number of other alternatives, such as paying the member off with half the stock and the balance in cash. For a more complete discussion of using stock to pay off departing members see Jerry's Best at
And, as always, if you have further questions, please come back. Thanks for using bivio.
Rip West
Ridgway, CO