Partnership Distributions

Whether earnings are retained in a partnership or distributed to partners has no affect on the taxation of those earnings, since the partners have to pay tax on the earnings whether they are distributed or not. Earnings are distributed to each partner's capital account from which distributions are charged against. However, certain types of distributions and any distributions that exceed the partner's basis may result in gains or losses that must be reported for the year in which they occur.

In order to understand the taxation of partnerships and distributions, it is necessary to know the 2 types of tax bases concerning partnerships. The inside basis is the partnership's tax basis in the individual assets. The outside basis is the tax basis of each individual partner's interest in the partnership. When a partner contributes property to the partnership, the partnership's basis in the contributed property is equal to its fair market value (FMV). However, the outside basis of the partner increases only by the amount of the basis that the partner had in the property.

Example: Inside and Outside Basis

You contribute land to a partnership in which you have a tax basis of $10,000 and an FMV of $50,000. Your other partner contributes $50,000 cash. Since the FMV of the land is also $50,000, you each have equal equity in the partnership, and the total inside basis of the partnership is equal to $100,000, your combined contributions. However, your outside basis differs from your partner's, since your outside basis is $10,000, while that of your partner's is $50,000. If you sold your partnership interest for $50,000, you would recognize a gain of $40,000, whereas your partner, if she sold at the same price, would recognize no gain.

There are 2 types of distributions: a current distribution decreases the partner's capital account without terminating it, whereas a liquidating distribution pays the entire capital account to the partner, thereby eliminating the partner's equity interest in the partnership. Generally, losses are only recognized in a liquidating distribution.

Cash Distributions

No gain is recognized from a distribution of cash or marketable securities that can easily be converted to cash, unless the distribution is more than the partner's outside basis, in which case, the excess is taxable as a capital gain.

Capital Gain = Cash Distribution – Partner's Outside Basis

Distributions are generally made throughout the year, but they are taken into account on the last day of the partnership's tax year. To minimize capital gains on distributions that may be greater than a partner's equity, the basis is 1st increased by the amount of income earned during the year, then it is decreased by any distributions: any excess distribution over the partner's basis is taxable as a capital gain.

Property Distributions

When property is distributed to a partner, then the partnership must treat it as a sale at fair market value (FMV). The partner's capital account is decreased by the FMV of the property distributed. The book gain or loss on the constructive sale is apportioned to each of the partners' accounts.

Generally, there are no tax consequences of a current property distribution — there is never a taxable gain or loss, either to the partnership or to the partner. The partnership's inside basis of the property carries over to become the partner's basis, thereby reducing the partner's outside basis by the carryover basis. As with the cash distribution, if the FMV of the property exceeds the partner's outside basis in the partnership, then the partner's interest in the partnership is reduced to 0 and the receiving partner's basis in the distributed property equals his outside basis in the partnership before the distribution. The property basis that remains after subtracting the outside basis is taxable as a gain.

Example: your adjusted basis in a partnership is $14,000. You receive a distribution of $8000 cash and land with a FMV of $3000 and an adjusted basis of $2000. Since the amount of cash received is less than your interest in the partnership, there is no taxable transaction. However, your outside basis in the partnership declines to $4000 (= $14,000$8000$2000). Subsequently, you receive a distribution of land with an adjusted inside basis of $10,000. Since your outside basis in the partnership is only $4000, your adjusted basis in the land is also $4000, and you must report a gain of $6000 (= $10,000$4000).

If distributed property also had a secured liability, then the partner assumes the liability which decreases her share of the partnership's liabilities. The other partners' share of liabilities is also decreased by the deemed distribution. If any part of the distribution is greater than a partner's basis in the partnership, then the excess is treated as a capital gain.

If a distribution involves unrealized receivables or substantially appreciated inventory items, defined as having a FMV exceeding 120% of the partnership's adjusted basis for the property, then the exchange may be treated as a sale or other taxable exchange, unless the partner contributed the property or the distribution was a distributive share or guaranteed payment to a retiring partner or a deceased partner's successor in interest.

If a partner receives an inventory item from the partnership, and the partner disposes of the item within 5 years, then he must recognize ordinary gain or loss on the property, regardless of whether it would otherwise be a capital asset.

Allocating Basis

When a partner receives a property distribution, the holding period for the property is added onto the holding period of the partnership plus the holding period of the partner who contributed the property, if applicable.

So if a partner contributed property, with a holding period of 1 year, to the partnership, and the partnership held the property for 2 years, then a distribution of that property to another partner would result in a carryover holding period of 3 years to the receiving partner.

If several properties are distributed to a partner, then basis must be allocated to the individual properties. Generally, the carryover basis of each property will be equal to the partnership's basis in the property, but since the total of the property basis cannot be greater than the partner's outside basis minus any money received, then any excess basis must be allocated among the properties.

Basis must 1st be allocated to unrealized receivables and inventory items. If there is any excess of basis over the partnership's interest, then the assigned bases must be reduced by the excess. Any remaining allocable basis is then assigned to the remaining properties, reduced by any excess of basis over the partner's remaining interest. Any basis increase should 1st be allocated to property with unrealized appreciation in proportion to that appreciation; any remaining basis should be allocated among all properties in proportion to their FMV.

If there is a decrease in basis, then the decrease should be allocated proportionally to the properties with unrealized depreciation; then any remaining basis decrease should be allocated to all properties in proportion to their basis.

Summary of the Allocation of Basis Rules to Liquidating Distributions

  1. Allocable basis = partner's outside basis – money received in final distribution.
  2. If allocable basis > 0, then
    1. Assign basis of unrealized receivables and inventory to the inside basis of property.
      1. Remaining allocable basis = allocable basis – assigned basis.
      2. If remaining allocable basis < 0, then decrease the basis of each assigned property by a proportional amount of the excess.
  3. If allocable basis = 0, then basis of all received property = 0.
  4. Assign basis of remaining property to inside basis of that property.
    1. Remaining allocable basis = remaining basis – assigned basis.
    2. If remaining allocable basis > 0, then
      1. Assign remaining allocable basis 1st to unrealized appreciated property to the extent of the appreciation.
      2. Allocate remaining allocable basis to all property in proportion to their FMV.
    3. If remaining allocable basis < 0,
      1. Allocate basis decrease 1st to those properties with unrealized depreciation.
      2. Allocate the remaining basis decrease to all received property to the extent of their assigned basis.
Example: Allocating Basis of a Distribution
Conditions
No inventory or significantly appreciated property.
Given Facts
1Partnership Outside Basis$60,000
2Land: adjusted inside basis$10,000
3Land: FMV$50,000
4Car: adjusted inside basis$10,000
5Car: FMV$10,000
Calculate Allocated Basis for Land and Car.
6Remaining basis to be allocated =
Outside Basis – (Land + Car Basis) =
$40,000
7Allocate remaining basis 1st to appreciated property$40,000= Land: FMVadjusted basis
Allocate remaining basis to all property in proportion to their FMV.
8Remaining basis to be allocated to all property = $40,000$40,000 =0
9Allocation of remaining basis to land0
10Allocation of remaining basis to car0
11Total Basis of Land$50,000= #2 + #7 + #9
12Total Basis of Car$10,000= #4 + #10
Example: Allocating a Decreased Basis of a Terminating Distribution
Conditions
No inventory or significantly appreciated property.
Given Facts
Land: adjusted inside basis$17,000
Land: FMV$17,000
Car: adjusted inside basis$13,000
Car: FMV$9,000
Calculate Allocated Basis for All Distributed Property
Total Basis of Property$30,000
Partner's Outside Basis$25,000
Unrealized Depreciation on Car =
Inside Basis of Car – FMV =
$4,000
Basis decrease to be allocated =
Outside BasisTotal Basis
($5,000)
Allocate basis decrease to car to the extent of unrealized depreciation,
then apportion remaining basis to all property in proportion to their reduced basis over the total basis.
Total Basis of Car = Inside Basis of Car – $4,000 Allocated Depreciation =$9,000
Remaining Reduced Basis to be Distributed to All Property
in Proportion to their Reduced Basis
$1,000
Total Reduced Basis of Land + Car$26,000
Additional Allocation of Basis Decrease to Car =
$1,000 × Reduced Basis of Car / Total Reduced Basis =
$346.15
Basis of Car = Total BasisAllocated Basis =$8,653.85
Remaining Basis Decrease Allocated to Land =
Total Distributed Basis ReductionCar Allocation =
$653.85
Basis of Land =$16,346.15
Check: Total Final Basis =
Car Basis + Land Basis = Partner's Outside Basis =
$25,000.00

Losses are only recognized in a liquidating distribution that consists of money, unrealized receivables, or inventory. In a liquidating distribution, if a partner's outside basis in the partnership exceeds the cash received plus the FMV of any property received, then the partner will recognize a loss to the extent of the excess.

So if a partner's outside basis was $100,000 in a partnership, but received $60,000 in cash and $10,000 worth of inventory items, then the terminating partner would recognize a capital loss of $30,000 (= $100,000 – $60,000 – $10,000).

In a liquidating distribution, the basis of property received by a partner is equal to the basis of the partnership interest minus any money received in the same transaction, so the carryover basis in the property can never be greater than the partner's outside basis in the partnership:

Partner's Basis in Property in Liquidating Distribution = Partner's Outside Basis – Money Received

Example: if a partner has an outside basis of $100,000 and receives a liquidating distribution of $140,000, then a $40,000 gain would be recognized, but if the $40,000 had been property and the rest cash, then the gain would not be recognized, but the partner's basis in the property would be zero, so taxes would have to be paid on the gain of the property when it is sold:

Partner's Basis in Property = $100,000 Outside Basis – $100,000 Cash Received

A gain or loss may also be recognized by a partner who contributes property to the partnership that, subsequently, is distributed to another partner within 7 years, in which case, the contributing partner would recognize a gain of the FMV of the property over the partner's original tax basis in the property.