Partner basis, Partnership Distributions

Whether earnings are retained in a partnership or distributed to partners has no effect 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 exceeding the partner’s basis may result in gains or losses that must be reported for the year when they occur.

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 = its fair market value (FMV). However, the outside basis of the partner increases only by the amount of the basis the partner had in the property.

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.

The basis of a partnership interest is increased by:

• The partner’s share of partnership taxable income, tax-exempt income.
• Additional contributions to the partnership or other forms of acquisition (e.g., purchases).
• Depletion deductions in excess of the basis of the property subject to depletion.
• An increase in the partner’s share of partnership liabilities (including partnership liabilities assumed by the partner).

A partner’s basis is decreased by:

• The partner’s share of partnership losses and non-deductible, non-capitalized expenditures, including the partner’s share of disallowed partnership losses if such losses reduce the basis of partnership assets without a corresponding effect on its income.
• Distributions of money or other property from the partnership.
• Any reduction in a partner’s allocable share of partnership liabilities. The IRS stated that a reduction in a partner’s share of partnership debt is treated as an advance of cash to the partner and is taken into account at the end of the partnership year. This ruling formalized existing IRS policy that the decrease in basis occurs on the last day of the year and not on the mid-year date when the partner’s share of debt declines.

Cash Distributions

No gain is recognized from a distribution of cash or marketable securities easily convertible 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

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 remaining after subtracting the outside basis is taxable as a gain.

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 exceeds a partner’s basis in the partnership, then the excess is treated as a capital gain.

If a distribution consists of 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.

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 property basis cannot exceed 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 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 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.