INCOME TAXATION OF FAMILY PARTNERSHIPS

 

A.        AGGREGATE V. ENTITY APPROACH TO PARTNERSHIP TAXATION. 

            Subchapter K (Sections 701 through 761) of the Internal Revenue Code (hereinafter the “Code”)¹ governs the federal income taxation of partners and partnerships.²  Under Subchapter K, a partnership can be treated either as a flow through conduit or as a separate entity.  For example, under § 701 of the Code, a partnership is not a taxable entity and incurs no federal income tax liability.  Instead, each partner in a partnership is required to take into account, in computing his federal income tax liability, his allocable share of income, gains, losses, deductions and credits of the partnership.³  In contrast to the conduit approach, the partnership is treated as existing separately from the partners and as owning the partnership property and conducting partnership business in its separate capacity.

 FORMATION OF PARTNERSHIP.

 

            In general, no gain or loss is recognized by a partnership or by any of the partners upon a contribution of property to the partnership in exchange for an interest in the partnership.⁴  This statutory nonrecognition provision applies only in the case where “property” is exchanged for an interest in the partnership.⁵  Generally, the courts and the IRS have defined the term property for purposes of §721(a) the same as under §351.  The nonrecognition of gain or loss upon the transfer of property in exchange for an interest in the partnership applies not only at formation of the partnership, but also at any time during the existence of the partnership.⁶ 

 

1.                  Transfers of Property to a Partnership that Constitutes an Investment Company.  The general nonrecognition rules of § 721(a) do not apply to gain realized upon the contribution of property to a partnership that would be treated as an investment company (within the meaning of § 351) if the partnership were an incorporated entity.⁷  The basic requirement for a partnership to be classified as an investment company is that the partnership is used principally as a vehicle to hold the investments portfolios of its partners. 

Even if the partnership is considered an investment company, the nonrecognition rules will still apply if there has been no diversification of the transferor’s investment portfolio.  Diversification will be found to occur if different transferors contribute different assets to the same partnership and the contributed assets are not diversified portfolios.  A de minims contribution is disregarded for this purpose.⁸  The regulations essentially provide that a transfer of stocks and securities is not treated as resulting in diversification of a partner’s interest if no one stock or security contributed to the partnership by a partner represents more than 25% of the value of the total assets be contributed by the partner and if no five or fewer securities contributed to a partnership by a partner represents more than 50% of the value of the total assets being transferred to the partnership by the partner.⁹

Although the regulations do not specify what qualifies as a de minims diversification, examples in the regulations and IRS private letter rulings indicate that diversification of 1% or less may be considered de minims.¹⁰  It should be noted that any cash contributed to a limited partnership is considered a non-identical asset to any security.  Therefore, if one partner contributes cash and the other contributes securities, diversification will occur unless the cash contribution satisfies the de minims exception.

 

2.                  Receipt of a Partnership Interest For Services.  A partner contributing services in exchange for a capital interest in the partnership will immediately recognize ordinary income equal to the value of the capital interest.¹¹  If receipt of the interest is contingent or subject to a substantial risk of forfeiture, recognition is delayed unless the partner elects to be taxed in the year of receipt.¹² 

However, if the partner contributing services receives a profits interests rather than a capital interests, he or she will not recognize income.  A profits interest is dependent upon future profits of the partnership as compared to a capital interest which includes the right to receive money or property upon the dissolution of the partnership.

Under Rev. Proc. 93-27, 1993 Cum Bull 343, the IRS will generally not tax the receipt of a profits interest to either the partner or the partnership except in the following three situations:

 

1.         The profits interest relates to substantial certain and predictable income.

2.         If, within two years of receipt, the partner disposes of the profits interests.

3.         A limited partnership interest in a publicly traded partnership is received.

The determination as to whether an interest is a capital interest or a profits interests is made at the time of receipt of the interest, even if, at the time, the interest is substantially nonvested under Reg. §1.83-3(b).  If the interest is a profits interest, the IRS will not tax the partner or partnership on either the receipt of the interest or the event that causes the interest to become substantially vested.

 

C.                 TAX BASIS

            Anyone attempting to work through a partnership tax issue must always remember that there are two distinct concepts of tax basis that applies in the context of a partnership.  First, the partnership, as an entity, has an adjusted basis in its assets.  The amount of its adjusted basis in its assets is significant in a variety of contexts including the computation of the amount of gain or loss realized by the partnership upon the sale of an asset.  Second, each partner has an adjusted basis in his partnership interest.

 

1.         Determination of Partner’s Initial Basis.  Section 722 of the Code provides that the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership is the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution is made increased by the amount (if any) of gain recognized under §721(b) to the contributing partner at such time.

Example: On January 1, 2002, Bob and John form an equal partnership.  Bob contributes $60,000 in cash and John contributes unencumbered property with a fair market value of $60,000 and an adjusted basis of $40,000.  Bob’s initial basis in his partnership interest is $60,000 (the amount of cash contributed).  John’s initial basis in his partnership interest is $40,000 (his adjusted basis in the contributed property).  The inherent gain in the property ($20,000), will be allocated to John pursuant to the rules in §704(c).¹³

 

2.                  Assumption of Liabilities.  Under §752(b), the partnership’s assumption of the contributing partner’s liabilities is treated as a deemed cash distribution from the partnership to the partner.  The contributing partner’s initial basis in his partnership interest is decreased by the amount of this deemed distribution.¹⁴  Conversely, under §752(a), any increase in a partner’s share of partnership liabilities is treated as a deemed cash contribution from the partner to the partnership.  As a result, the contributing partner’s initial basis in his partnership interest is increased by the amount of the deemed cash contribution.¹⁵

A contribution of property encumbered by recourse debt results, therefore, in two separate simultaneous basis adjustments—a decrease in basis equal to the amount of the liabilities assumed by the partnership and an increase in basis equal to the contributing partner’s share of such amount.  The two basis adjustments are netted against each other and only the net decrease or increase is treated as a deemed distribution or contribution.¹⁶

Any net decrease, treated as a deemed distribution, cannot reduce the contributing partner’s basis in his partnership interests below zero.¹⁷  The contributing partner recognizes taxable gain to the extent that the deemed cash distribution exceeds the contributing partner’s basis in his partnership interest.¹⁸  The other partners’ bases in their partnership interests are increased to the extent of any increase in their respective shares of partnership liabilities resulting from the partnership’s assumption of the liabilities encumbering the contributed property.¹⁹

Example: Assume that on January 1, 2002, Bob and John form an equal partnership.  Bob contributes $60,000 of cash, John contributes property with a fair market value of $60,000, an adjusted basis of $40,000, subject to a recourse liability of $10,000.  Bob’s initial basis in his partnership interest is $65,000 ($60,000 cash contribution plus Bob’s share (50%) of the partnership’s $10,000 recourse liability).  John’s initial basis in his partnership interest is $35,000 ($40,000 minus $5,000 of recourse liability allocated to Bob).

Example: On January 1, 2002, Bob and John form an equal partnership.  Bob contributes $60,000 of cash.  John contributes property with a fair market value of $60,000, an adjusted basis of $10,000, subject to a recourse liability of $40,000.  Bob’s initial basis in his partnership interest is $80,000 ($60,000 cash contributed plus Bob’s share (50%) of the partnership’s $40,000 recourse liability).  John’s initial basis in the partnership interest is zero ($10,000 adjusted basis in contributed property, minus the $10,000 portion of the recourse liability allocated to Bob).  Note that the full amount of the liability that should be allocated to Bob is $20,000 but John’s adjusted basis in his partnership interest cannot be reduced below zero.  The remaining $10,000 of liability results in recognized gain of $10,000.  This gain is treated as gain from the sale or exchange of a newly acquired partnership interest, a capital asset, and not as gain from the sale or exchange of the contributed property.

 

3.                  Contribution of Property Encumbered by Nonrecourse Liabilities.  If a partner contributes property that is encumbered by nonrecourse liabilities, the results are somewhat different from those described above.  A nonrecourse liability is defined in Regs. §1.752(a)(2) as a liability for which no partner or related person bears the economic risk of loss.  Generally, a contributing partner is allocated a portion of the nonrecourse liability at least equal to the difference between the contributing partner’s adjusted basis in the contributed property and the amount of the nonrecourse liability.²⁰  In addition, the contributing partner is allocated a portion of the remainder of the liability.²¹

Example:  On January 1, 2002, A and B form an equal partnership.  A contributes $50,000 of cash, B contributes property with a fair market value of $50,000 and an adjusted basis of $10,000, subject to a nonrecourse liability of $30,000 assumed by the partnership.  B’s share of the nonrecourse liability is $25,000 ($20,000 under the built-in gain rule of Regs.§1.752-3(a)(1) and (2) ($30,000 liability less the $10,000 adjusted basis) plus 50% of the $10,000 Regs.§§1.752-3(a)(3) “excess” nonrecourse liability.)  A’s share of the nonrecourse liability is $5,000 (50% of the $10,000 “excess” nonrecourse liability.)  A’s initial basis in his partnership is $55,000 cash contributed plus $5,000 nonrecourse liability).  B’s initial basis in his partnership is $5,000 ($10,000 adjusted basis in contributed property minus $5,000 portion of nonrecourse liability allocated to A).

 

4.                  Partnership Interest Acquired Other Than by Contribution.  Under § 742, the basis to a transferee partner of an interest in a partnership acquired other than by contribution is determined by application of the general basis rules for property provided in Part II §1011 et seq.), Subchapter 0, Chapter 1 of the Code.²²  Under these general rules, the basis of a partnership interest acquired by purchase is its cost.²³  Therefore, if a transferee partners pays cash for his interest, his initial basis in his interest is the amount of cash paid.

 

5.                  Acquisition of Partnership Interest from a Decedent.  The initial basis of a partnership interest acquired from a decedent is the fair market value of the interest at the date of death or at the alternative valuation date.²⁴  The estate’s or other successor’s basis in the partnership interest is increased by its allocable share of partnership liabilities and decreased to the extent that the fair market value of the interest is attributable to items constituting income in respect of a decedent.²⁵

 

6.                  Acquisition of Partnership Interest by Gift.  Generally, §1015 provides that the initial basis of a partnership interest acquired by gift is the donor’s adjusted basis in the interest prior to the transfer.  However, for purposes of determining loss realized upon the sale or other disposition of such interest, the donee’s basis is limited to the fair market value of the interest at the time of the gift.²⁶

Example:  In 2002, Father gives Son a partnership interest with a fair market value of $100,000 and an adjusted basis in his hands prior to the transfer of $40,000.  Son’s initial basis in the interest is $40,000.

Example:  In 1994, Father gives Son a partnership interest with a fair market value of $30,000 and an adjusted basis in his hands prior to the transfer of $40,000.  Son’s initial basis in the interest is $40,000, unless Son subsequently sells or disposes of his interest at a loss.  For instance, if Son sells his interest for $50,000 and there have been no adjustments to his basis in the partnership, Son will recognize $10,000 of gain ($50,000 amount realized minus $40,000 adjusted basis).  If, on the other hand, Son sells his interest for $20,000 and there have been no adjustments to his basis in his partnership, Son will recognize only $10,000 of loss ($30,000 adjusted basis, minus the $20,000 amount realized) because his basis is limited to the fair market value of the interest at the time of the gift ($30,000).

 

D.                 PARTNERSHIP’S BASIS IN CONTRIBUTED ASSETS.

            A partnership’s basis in property contributed to it y a partner is equal to the contributing partner’s adjusted basis in the property at the time of the contribution plus the amount of gain recognized by the contributing partner under § 721(b)²⁷.  This means that a partnership has a carryover basis in contributed property with the exception of contributions to partnerships that qualify as investment companies which result in the recognition of gain by the contributing partner. 

            A partnership’s basis in encumbered contributed assets is not increased by the amount of any gain recognized by the contributing partner as a result of a decrease in the partner’s share of liabilities under § 731(a) and 752(b).  Any such gain is treated as arising after the contribution and not at the time of the contribution²⁸.

E.                  THE PARTNERSHIP’S HOLDING PERIOD FOR CONTRIBUTED PROPERTY.

            Under § 1223(2), the holding period for property contributed to a partnership by a partner includes the property’s holding period in the hands of the contributing partner.  § 1223(2) applies without regard to the character of the contributed property, i.e., inventory or capital assets in the hands of the transferor.

F.                  ADJUSTMENTS TO PARTNER’S INITIAL BASIS.

            Section 705 of the Code provides that the adjusted basis of a partner’s interest in a partnership interest is increased by the partner’s distributive share of partnership taxable income (as determined under §703(a) and §704), partnership exempt income, and the excess of the deductions for depletion over the basis of the property subject to depletion²⁹.  In addition, the adjusted basis of the partner’s interest in a partnership is increased by any additional contributions to the partnership.³⁰  The adjusted basis of a partner’s interest in a partnership is decreased (but not below zero) by distributions governed by §733 and by the partner’s distributive share of partnership losses and by expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account.³¹

            A partner’s adjusted basis in a partnership interest is decreased by distributions before it is decreased by the partner’s distributive share of partnership losses.³²

Example:  A and B are equal partners in a partnership.  A’s adjusted basis in his partnership interest is $10,000.  During the taxable year, the partnership distributes $8,000 of cash to A and A’s distributive share of partnership losses is $5,000.  A’s adjusted basis is first decreased by the amount of the cash distribution.  Thus, after the distribution, A’s adjusted basis is $2,000 ($10,000 minus $8,000).  Next, A’s basis is decreased by A’s distributive share of partnership losses ($5,000) but only to the extent that such losses do not reduce A’s basis below zero.  Thus, A’s adjusted basis in his partnership interest is zero and A is entitled to deduct only $2,000 of his $5,000 distributive share of partnership losses.³³

G.                 SECTION 754 ELECTION

            Section 754 provides that if a partnership elects, the underlying assets of the partnership can be adjusted with respect to:

1.                  The purchaser of an interest; or

2.                  A transferee by reason of the death of a partner.

            The basis adjustment applies only to the transferee partner.  The election under §754 must be made by filing a written statement along with the partnership’s tax return for the year in which then death or purchase occurred.  For the §754 election to be valid, the return must be filed no later than the time prescribed for filing the return for such taxable year, including extensions.  In order to file the § 754 election due to the death of a partner, the partnership must have the fair market value of the partnership reported on the decedent’s estate tax return.

 

H.                 COMPUTING THE PARTNERSHIP TAXABLE INCOME

            Although the partnership is not a separate taxpaying entity, its taxable income is computed at the entity level³⁴. Additionally, § 702(a) requires specific items of partnership income, gain loss, and deduction and credit to be segregated from the partnership taxable income and included as separate items on the partners’ individual returns.  The process of separately stating certain partnership items preserves the tax character of such items in the hands of the partners.

            The tax character of most “separately stated” items is determined at the entity level, by reference to the activity of the partnership³⁵.  Such items include

 

‚                   short-term capital gains and losses;

‚                   long-term capital gains and losses;

‚                   IRC 1231 gains and losses;

‚                   charitable contributions as defined in IRC §170(c);

‚                   dividends eligible for deduction under §241-249;

‚                   IRC §901 taxes paid or accrued to foreign countries and possessions of the United States;

‚                   IRC §212 nonbusiness expenses;

‚                   IRC §213 medical and dental expenses;

‚                    IRC §263(c) intangible drilling and development costs.  

1.                  IRS Form 1065, Schedule K-1 (1065).  In general, a partnership must file form 1065 with the IRS for each year it receives income or incurs expenditures allowable as deductions.  The partnership must file Form 1065 on or before the fifteenth day of the fourth month following the end of each taxable year.  The partnership may obtain an automatic three month extension on application of IRS Form 8736.  The extension does not operate to extend the time for filing the partners’ income tax return. 

            In addition, the partnership must provide each partner with the following:

 

‚                   a copy of the information shown on the partnership’s Form 1065;

‚                   a statement reflecting the partner’s distributive share of partnership income, gain, loss, deduction, credit and other tax items (Schedule K-1, 1065);

Schedule K-1 must be furnished on or before the due date for the partnership’s tax return, determined without regard to extensions.

 

2.                  Colorado Tax Returns.  Along with Form 1065, the partnership must file Form 106 with the Colorado Department of Revenue.  If the partnership has one or more partners who are nonresidents of Colorado, it must file a list of partners and consents on Form 107.  The purpose of Form 107 is for each nonresident partner to consent to the jurisdiction of Colorado and to agree to file all necessary tax returns and make timely payment of any tax due from Colorado source income.  If the nonresident partner refuses to sign the consent, the partnership must withhold tax on the amount of Colorado source income at the highest marginal rate.  The nonresident partner may claim such payment as an estimated tax payment upon filing of their individual tax return.

 

I.                    SELECTING A TAX YEAR

            The taxable year of the partnership is determined as though the partnership were a separate taxpayer³⁶.  However, a partnership is severely limited in its ability to use a tax year that differs from that of its partners.  In general, a partnership must adopt the same taxable year as those of its partners who own, in the aggregate more than 50% of the partnership profits and capital.³⁷  A partnership can elect an alternative taxable year only if it can establish to the satisfaction of the IRS, a sufficient business purpose for the other taxable year.³⁸

 

J.                   PARTNER’S DISTRIBUTIVE SHARE

            A partner’s distributive share represents the partner’s share of overall Partnership income, gain, loss, deduction, and credit.³⁹  Due to the pass-through nature of Partnership taxation, each partner is taxed on his or her distributive share of income, regardless of whether such partner receives a corresponding distribution of cash or property from the Partnership.  Partners report their distributive shares on their personal income tax returns for the year in which the Partnership’s taxable year ends.⁴⁰

 

1.                  Determining a Partner’s Distributive Share.  The partners can decide, by placing specific provisions in the Partnership agreement, what each partner’s distributive share of Partnership income, gain, loss, deduction, or credit will be.⁴¹  This freedom of the partners to allocate Partnership tax items among themselves in a manner that takes into account their individual economic objectives, and tax situations is one of the primary benefits of the Partnership.  However, the paramount importance given to the agreement of the partners by IRC §704(a) is not unfettered; other provisions of the Internal Revenue Code restrict their freedom to allocate, e.g.:

 

a.                   If the partners’ agreement as to distributive shares lacks substantial economic effect, allocations are subject to reallocation unless they are in accordance with the partner’s interest in the Partnership.⁴²

b.                  All tax items with respect to property contributed by a partner to an Partnership must take into account variations between the basis of the property to the Partnership and its value when contributed.⁴³

The restriction in item (a) above limits special allocations that the partners may wish to include in their partnership agreement to ensure that the tax consequences of allocations conform to the economic consequences.  In drafting the partnership agreement, the practitioner must understand and test the determination of distributive shares to ensure that they will be respected by the IRS under IRC §704(b).  Under the regulations to §704(b), an allocation of income, gain, loss, deduction or credit to a partner will be respected if it:

 

•                     has substantial economic effect⁴⁴; or

•                     is in accordance with the partner’s interest in the Partnership.⁴⁵

Allocations with “substantial economic effect” are decreed to be in accordance with a partner’s interest in the Partnership.

 

2.                  Allocations with Substantial Economic Effect.  Subject to special rules for nonrecourse deductions, allocations of Partnership income, gain, loss, deduction, or credit will be deemed to accord with the partners’ interests within the meaning of IR §704(b) under the following four conditions:

a.                   Such allocations are reflected in specially maintained capital accounts as defined in the regulations;

b.                  On liquidation, liquidating distributions are to be made in accordance with positive capital account balances;

c.                   When a partner has a deficit balance in his or her capital account, the partner is unconditionally obligated to restore the deficit on liquidation or, in the alternative, is subject to a qualified income offset; and

d.                  The economic effect of such allocations is “substantial.”⁴⁶

 

K.                CAPITAL ACCOUNT MAINTENANCE

            The Partnership agreement must provide that capital accounts will be established and maintained in accordance with the provisions set forth in Reg. §1.704-1(b)(2)(iv).   It is important to understand that a partner’s capital account balance is generally not identical to the basis of that partner’s Partnership interest.  As a result, a partner’s capital account cannot be relied on to determine a partner’s adjusted basis.

            Although the formulas for calculating the two are similar, major differences can arise for two primary reasons: First, a partner’s share of liabilities under §752 is not taken into account in determining his or her capital account balance.⁴⁷  Second, a capital account is adjusted by the net fair market value, rather than the adjusted basis, of assets contributed to or distributed by the Partnership.⁴⁸

1.                  Liquidating Distributions.  The Partnership’s  agreement must provide that liquidation payments (after payments to creditors) will be distributed to the partners in accordance with their positive capital account balances either by the end of the Partnership taxable year in which the Partnership is liquidated, or, if later, within 90 days after the date of such liquidation.⁴⁹

 

2.                  Capital Account Deficit Restoration Requirement.  The Partnership’s agreement must include a “deficit restoration requirement” or, alternatively, a “qualified income offset provision.”  A deficit restoration requirement requires any partner who as a negative capital account balance on liquidation to contribute cash to the Partnership in an amount sufficient to restore that partner’s capital account balance to zero either by the end of the Partnership taxable year during which liquidation occurs, or, if later, within 90 days after liquidation.⁵⁰

A capital account “deficit restoration requirement” effectively subjects a partner to an unlimited capital contribution obligation.  Given the limited liability of limited partners in a Limited Partnership, a “qualified income offset” provision is likely to be more appropriate than a “deficit restoration requirement” in a Limited Partnership agreement, and the economic effect requirement will still be satisfied.

 

3.                  Qualified Income Offset.  Under a qualified income offset, if a partner unexpectedly incurs a negative capital account balance, that partner will be allocated items of income and gain to return his or her capital account balance to zero as quickly as possible.⁵¹   An allocation under this alternative test is valid only if it will not create or increase a deficit in a partner’s capital account after the capital account is reduced to reflect certain adjustments and distributions that are reasonably expected to occur in the future.

 

L.                  LIMITATIONS ON DEDUCTIBILITY OF PARTNER’S SHARE OF PARTNERSHIP LOSSES

            A partner’s deduction of Partnership losses is subject to three limitations: basis, at risk, and passive loss, applied in that order.⁵²  Since disallowed losses are suspended and can be carried over, the limitations actually relate to when the losses can be taken by a partner.

 

1.                  Basis Limitation.  A partner’s distributive share of Partnership losses is deductible only to the extent of the adjusted basis of the partner’s Partnership interest at the end of the Partnership taxable year in which the loss occurs.⁵³  That portion of a partner’s distributive share of Partnership losses that is disallowed in any year can be carried over and deducted in subsequent years to the extent of the partner’s adjusted basis.⁵⁴

If a partner’s distributive share of Partnership losses consists of capital, ordinary income, and other loss items, but is only partially deductible in a given year, the deductible portion is allocated among the different loss components in proportion to their respective amounts.⁵⁵

Even if the adjusted basis of a partner’s Partnership interest is sufficient to absorb his or her distributive share of Partnership losses, all or a portion of such losses may still be disallowed under the “at risk” limitations, the passive loss limitations, or other loss limitations. 

 

M.               CURRENT DISTRIBUTIONS TO A PARTNER

            A partner’s distributive share of Partnership income is an allocation for tax purposes only.  The partner must pay tax on his or her distributive share of Partnership income, regardless of whether he or she receives such income.  However, a current distribution represents money or property that the Partnership actually distributes to the partner.  Whether the partner will be taxed on a distribution depends on the nature and timing of the distribution.

 

1.                  Distribution of Cash.  The general rule is that a partner recognizes gain on the Partnership’s distribution of money to the partner only to the extent that the amount of money exceeds the adjusted basis of his or her Partnership interest.⁵⁶ Money includes marketable securities.

 

2.                  Distributions of Other Assets.  In general, neither a Partnership nor its partners recognize gain or loss on the Partnership’s current distribution of property to a partner.⁵⁷  One or more of the exceptions to this provision discussed below, may cause either the Partnership or its partners to recognize gain when it distributes property to a partner.

If the Partnership intends to distribute both cash and property during the same year, generally the cash distribution should be made first, unless the distributee partner wishes to recognize gain.  This order is advisable because making the property distribution first would reduce the basis of the distributee’s Partnership interest by the Partnership’s interest in the distributed property, thereby reducing the amount of basis that the partner can set off against the subsequent cash distribution. 

 

3.                  Distributions Relating to Built-In Gain Property.  The term “built-in gain property” refers to property that a partner contributes to an Partnership that has a fair market value which differs from its tax basis on the date of contribution.  If the Partnership sells the built-in gain property, or distributes it to another partner within five years after the date of contribution, the contributing partner must recognize the built-in gain attributable to the property.⁵⁸  Built-in gain for these purposes generally equals the fair market value of the property at the time of contribution minus the adjusted tax basis for such property.⁵⁹

The partner contributing property with the built-in gain also must recognize gain on any distribution of property (other than cash or the property contributed to the Partnership by the partner receiving such distribution) within five years of the contribution, to the extent of the lesser of:

a.         the excess of the fair market value of the property distributed over the partner’s basis for his or her Partnership interest, reduced by any money distributed, or

b.                  the net precontribution gain of the partner.⁶⁰ 

Net precontribution gain is the net gain attributable to any property held by the Partnership on the date of the distribution that was contributed to the partnership within the preceding five-year period.⁶¹

 

N         LIQUIDATING PAYMENTS TO A PARTNER

            When a partner dies or withdraws from the Partnership, voluntarily or involuntarily, a number of tax and operational consequences may result.  Under the terms of the partnership agreement, the Partnership may dissolve.  The interest of the terminating partner may be transferred by sale to a partner or nonpartner or transferred to the heir who becomes a partner.  The third alternative is that the Partnership may liquidate the interest of the withdrawing or deceased partner by making liquidating payments from the Partnership under §736.  The Partnership may structure the termination to achieve the desired result.

 

1.                  When Payments Are Liquidating Payments.  A partner receives liquidating payments, as opposed to current distributions, when the partner completely withdraws from the Partnership because of death or retirement.⁶²

Liquidating payments are payments to the partner of his or her interest in the Partnership property and, except for §736(a) payments are generally nondeductible distributions by the Partnership and taxed as a capital transaction to the withdrawing partner.

 

2.                  Liquidating Payments Distinguished From Sales Proceeds.  The tax consequences of a partner’s transfer of an Partnership interest by sale or exchange may differ significantly from a liquidation, even when the economic consequences are the same.  In a liquidation, a partner receives payments from the Partnership in exchange for an Partnership interest; in a sale or exchange a partner receives consideration from another partner or a third party in exchange for an Partnership interest.

 

3.                  Amount of Gain or Loss to Selling Partner.  A partner’s sale or exchange of a Partnership interest is taxable in the same manner as the sale or exchange of other kinds of property.  Accordingly, the selling partner recognizes gain or loss equal to the difference between the amount realized and the adjusted basis of his or her Partnership interest at the time of the sale.⁶³  A selling partner may not, however, recognize or deduct a loss resulting from the sale if the sale is to a related party. ⁶⁴

The amount a partner realizes on the sale or exchange of a Partnership interest includes not only the sum of any money and the fair market value of any property received for the Partnership interest, but also the selling partner’s share of Partnership liabilities under §752.⁶⁵  When the aggregate amount of Partnership liabilities included in the basis of the selling partner’s Partnership interest exceeds his or her adjusted basis for that Partnership interest, the partner will recognize phantom gain equal to the amount of the excess. ⁶⁶

 

4.                  Character of Gain or Loss.  Gain or loss recognized on the sale or exchange or all or any part of an Partnership interest is treated as gain or loss from the sale of a capital asset, except to the extent that §751(a) applies.  Under §751(a), gain or loss attributable to §751 property is treated as gain or loss from the sale of a noncapital asset and as ordinary income.  §751 property consists of unrealized receivables and substantially appreciated inventory.

 

Allocation of Partnership Tax Items.  If a partner sells or exchanges his or her entire Partnership interest, the Partnership’s taxable year closes with respect to that partner on the date of the sale. ⁶⁷.  The selling partner must report his or her distributive share of Partnership income, gain, loss, deduction and credit and other tax items on his or her tax return for the year in which the sale occurs.⁶⁸  If a partner sells or exchanges only part of his or her Partnership interest, the Partnership’s taxable year dose not close with respect to that partner.⁶⁹ Instead, the Partnership’s taxable year continues to its normal close, and the seller and purchaser determine their distributive shares of Partnership income, gain, loss, deduction and credit and other tax items for the taxable year by taking into account their varying interests in the Partnership during the taxable year.⁷⁰