A tax basis capital account example is easiest to follow as a running balance: start with last year’s ending figure, add contributions and the partner’s share of income, subtract distributions and the partner’s share of losses, and value any property that moves in or out at its adjusted tax basis rather than fair market value. That ending number is what the partnership reports in Item L of each partner’s Schedule K-1.1Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025) – Section: Item L
The mechanics look simple written out. They get tricky when property is involved, when the partnership earns tax-exempt income, or when guaranteed payments are in the mix. Working an example across several years makes each piece concrete.
The Four Adjustments That Drive the Number
Every tax basis capital account moves through the same four categories each year: capital contributed, current-year net income or loss, withdrawals and distributions, and other increases or decreases computed consistently with the rules for the partner’s adjusted basis, ignoring partnership liabilities.1Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025) – Section: Item L
Cash contributions go in at face value. Property contributions go in at the contributing partner’s adjusted tax basis, not fair market value. If you contribute equipment worth $50,000 that you have depreciated down to $12,000, only $12,000 hits the capital account.
Income allocations increase the account. This includes ordinary business income, capital gains, interest, and tax-exempt income such as municipal bond interest. The allocation increases the capital account whether or not any cash is distributed.
Cash distributions reduce the account dollar for dollar. Property distributions reduce it by the partnership’s adjusted tax basis in the distributed property, again not by market value.
Losses and nondeductible expenses reduce the account. That covers ordinary losses, capital losses, disallowed meals, penalties, and Section 179 expense deductions allocated to the partner in the year the property is placed in service.
Three Years of Activity for a 50/50 Partner
Consider Alpha Ventures LLC, a partnership with two equal members. Follow Partner A from formation through Year 3.
Year 1: Contribution, Income, and a Distribution
Partner A contributes $50,000 cash on January 1. The capital account opens at zero and jumps to $50,000.
Alpha Ventures earns $120,000 in ordinary business income for the year. Partner A’s 50% share is $60,000, which increases the capital account whether or not A receives any cash.
In December, the partnership distributes $30,000 cash to Partner A. That reduces the capital account by $30,000.
Year 1 ending balance: $0 + $50,000 − $0 + $60,000 − $30,000 = $80,000. That figure appears in Item L of Partner A’s Year 1 K-1.
Year 2: A Loss and a Property Contribution
Partner A begins Year 2 at $80,000. The partnership loses money, reporting a $40,000 net ordinary loss. Partner A’s 50% share is $20,000, which reduces the capital account.
Midyear, Partner A contributes equipment. The equipment has a fair market value of $10,000, but Partner A’s adjusted tax basis in it is only $4,000. For the tax basis capital account, only the $4,000 matters. The $10,000 market value is irrelevant here, though it does drive the Section 704(b) book capital account and creates a Section 704(c) disparity that governs future depreciation allocations.2eCFR. 26 CFR 1.704-3 – Contributed Property
No distributions occur in Year 2.
Year 2 ending balance: $80,000 − $20,000 + $4,000 = $64,000.
Year 3: Tax-Exempt Income and a Property Distribution
Partner A starts Year 3 at $64,000. The partnership earns $10,000 of tax-exempt municipal bond interest. Partner A’s 50% share is $5,000. Even though this income does not appear on A’s tax return as taxable, it still increases the tax basis capital account because it represents economic value flowing into the partnership.
The partnership then distributes property to Partner A. The property has a fair market value of $50,000, but the partnership’s adjusted tax basis in it is $20,000. The capital account drops by $20,000, not $50,000.
Year 3 ending balance: $64,000 + $5,000 − $20,000 = $49,000. That number appears in Item L of Partner A’s Year 3 K-1.
Notice the pattern across the three years. Cash moves at face value. Property moves at tax basis, whether it is coming in or going out. Income increases the account whether or not cash follows, and tax-exempt income counts too.
Why the Capital Account Is Not the Same as Outside Basis
The IRS instructions themselves flag a point that trips up many partners: the capital account analysis in Item L is based on the partnership’s books and records and “can’t be used to figure the partner’s adjusted basis.”3Internal Revenue Service. Partner’s Instructions for Schedule K-1 (Form 1065) (2025) – Section: Basis Limitations The tax basis capital account deliberately excludes the partner’s share of partnership liabilities. Outside basis, the number that actually controls how much loss you can deduct, equals the tax basis capital account plus your share of partnership debt plus any Section 743(b) basis adjustments.4IRS. Partner’s Outside Basis
That distinction matters most when the capital account is negative. A negative balance means cumulative losses and distributions have outpaced contributions and income. Outside basis can still be positive if the partner’s allocated share of partnership debt is large enough. Under Section 704(d), a partner can only deduct losses up to the adjusted basis of the partnership interest at the end of the tax year, with excess losses suspended until basis is restored.5Office of the Law Revision Counsel. 26 USC 704 – Partner’s Distributive Share
Increases in a partner’s share of partnership liabilities are treated as cash contributions for outside basis purposes, and decreases are treated as cash distributions. A refinancing or payoff that shrinks your liability share can create a deemed distribution large enough to trigger gain if it exceeds outside basis. None of that shows up in Item L, which is one reason partners keep their own outside basis worksheet in parallel.
Guaranteed Payments in the Calculation
Guaranteed payments create two simultaneous effects on a partner’s capital account, and they are easy to double-count or miss. A guaranteed payment is compensation determined without regard to partnership income; the partnership deducts it like a salary expense, and the partner reports it as ordinary income.6Internal Revenue Service. Publication 541 Partnerships
Take a 50/50 partnership that earns $40,000 of ordinary income before considering a $10,000 guaranteed payment to Partner A. On the income side, the partnership deducts the $10,000, leaving $30,000 of ordinary income. Partner A’s 50% share of that is $15,000. Partner A also reports the $10,000 guaranteed payment as income. Total income flowing to A on the K-1: $25,000. On the withdrawal side, the $10,000 cash payment is a distribution that reduces A’s capital account.
Net effect on Partner A’s capital account: +$25,000 in income allocations, −$10,000 in withdrawals, for a $15,000 increase. Without the guaranteed payment, A’s share of $40,000 would have been $20,000 with no offsetting withdrawal. The $5,000 difference reflects Partner B absorbing half of the guaranteed payment deduction on B’s own income allocation.
When a Partnership Doesn’t Have to Complete Item L
Not every partnership has to report capital accounts. A partnership that answers yes to all conditions in Schedule B, Question 4 of Form 1065 is excused from completing Schedules L, M-1, M-2, and Item L on each K-1. Two of the key thresholds are total receipts under $250,000 for the year and total assets under $1 million at year-end.7Internal Revenue Service. Partnership Instructions for Schedules K-2 and K-3 (Form 1065) (2025)
Partnerships that qualify for the exception often complete Item L anyway. Partners still need to track their own outside basis, and having the partnership’s calculation as a starting point saves work later, especially when a partner eventually sells the interest or receives a liquidating distribution and has to recognize gain or loss against basis.