1. Chapter 11 Partnerships: Distributions, Transfer of Interests,
and Terminations
William H. Hoffman, Jr., William A. Raabe,
James E. Smith and David M. Maloney
Copyright ©2002 South-Western/Thomson Learning, Cincinnati, Ohio

2. Distributions From A Partnership (slide 1 of 4)
All distributions of cash and property fall into two categories:
Liquidating distributions
Nonliquidating distributions
Depends on whether the partner remains a partner in the partnership after the distribution

3. Distributions From A Partnership (slide 2 of 4)
A liquidating distribution occurs when either:
Partnership itself liquidates and distributes all its property to the partners, or
Ongoing partnership redeems interest of one of its partners
e.g., Partner retires

4. Distributions From A Partnership (slide 3 of 4)
A nonliquidating distribution is any distribution from a continuing partnership to a continuing partner
Two types of nonliquidating distributions
Draw
Distribution of partner’s share of current or accumulated profits
Partially liquidating distribution
Reduces partner’s interest in partnership capital but does not liquidate partner’s interest

5. Distributions From A Partnership (slide 4 of 4)
Distributions from a partnership may be either:
Proportionate - Partner receives his or her share of certain ordinary income-producing assets
Disproportionate - Partner’s share of certain ordinary income-producing assets increases or decreases

6. Proportionate Nonliquidating Distributions (slide 1 of 3)
Neither partner nor partnership recognizes gain or loss on proportionate nonliquidating distributions
Partner usually takes a carryover basis in assets distributed
Basis in partnership interest is reduced by amount of cash and basis of property distributed

7. Proportionate Nonliquidating Distributions (slide 2 of 3)
Partner recognizes gain to extent cash received exceeds partner’s adjusted basis in partnership interest
Partner cannot recognize loss in a nonliquidating distribution

8. Proportionate Nonliquidating Distributions (slide 3 of 3)
Property distributions
No gain recognized on a property distribution
If inside basis of property distributed exceeds partner’s outside basis in partnership interest, distributed asset takes substituted basis
Assets are deemed distributed and basis applied in a certain order

9. Ordering Rules 1. Cash 2. Unrealized receivables and inventory
3. All other assets
Basis is allocated to assets within a category based on adjusted basis to partnership

10. Proportionate Nonliquidating Distribution Examples (slide 1 of 6)
Bill's basis in partnership interest: $30,000
Proportionate nonliquidating distributions
( independent fact situations):
A B C
Cash $15,000 $15, $ 5,000
Land - basis N/A $ 6, N/A (Fair mkt value) N/A $10,000 N/A
Accts rec -basis N/A N/A
(Fair mkt value) N/A N/A $16,000

11. Proportionate Nonliquidating Distribution Examples (slide 2 of 6)
A B C
Basis in interest $30,000 $30, $30,000
Cash distributed ( 15,000) (15,000) (5,000)
Basis after cash 15, , ,000
Acct. rec. distrib. N/A N/A (-0-)
Basis after A.R. 15, , ,000
Land Distrib N/A ( 6,000) N/A
Basis after all dist. $15,000 $ 9,000 $25,000

12. Proportionate Nonliquidating Distribution Examples (slide 3 of 6)
A B C
Basis in p'ship int. $15,000 $9,000 $25,000
Basis in cash 15,000 15, ,000
Basis in land N/A 6, N/A
Basis in A/R N/A N/A
Total basis $30,000 $30,000 $30,000
Sale of non-cash assets
at FMV: Selling price N/A $10,000 $16,000
Basis N/A (6,000) (-0-)
Gain N/A $4,000 $16,000

13. Proportionate Nonliquidating Distribution Examples (slide 4 of 6)
Bill's basis in partnership interest: $30,000
Proportionate nonliquidating distributions
( independent fact situations):
D E F
Cash $40,000 N/A $20,000
Relief of liabilities N/A 40, N/A
Land -basis N/A N/A $30,000
(Fair mkt value) N/A N/A $50,000

14. Proportionate Nonliquidating Distribution Examples (slide 5 of 6)
D E F
Basis in interest $30,000 $30,000 $30,000
Cash distributed (40,000) N/A (20,000)
Relief of liabilities N/A (40,000) N/A
Gain recognized 10, , N/A
Basis after cash (and
deemed cash) dist ,000
Land distrib. N/A N/A (10,000)
Basis after all distrib

15. Proportionate Nonliquidating Distribution Examples (slide 6 of 6)
D E F
Basis in p'ship int
Basis in cash 40, N/A 20,000
Liabilities relieved N/A 40, N/A
Basis in land N/A N/A 10,000
Gain recognized (10,000) (10,000) N/A
Original basis 30, , ,000
Sale of non-cash assets
at FMV: Selling price N/A N/A $50,000
Basis N/A N/A (10,000)
Gain N/A N/A $40,000

16. Effect of Liquidating Distribution
In general:
No gain or loss is recognized
Partner reduces basis in partnership interest by basis in property received at each level using Ordering Rules
Partner’s entire basis in interest will be absorbed by distributed assets

17. Exceptions to Liquidating Distribution Rules (slide 1 of 2)
Gain is recognized if:
Cash distributed exceeds partner’s basis
Precontribution gain exceptions
Disproportionate distribution

18. Exceptions to Liquidating Distribution Rules (slide 2 of 2)
Loss is recognized only if:
Assets received include ONLY cash, unrealized receivables and inventory, and
Outside basis exceeds partnership’s inside basis in distributed property

19. Proportionate Liquidating Distribution Examples (slide 1 of 4)
Bill's basis in partnership interest: $30,000
Proportionate liquidating distributions (partnership also liquidates) ( independent fact situations):
G H I
Cash $50,000 $10,000 $10,000
Unrealized rec. N/A
(Fair mkt value) N/A $16,000 $16,000
Filing cabinet (1231) N/A N/A
(Fair mkt value) N/A N/A

20. Proportionate Liquidating Distribution Examples (slide 2 of 4)
G H I
Basis in interest $30,000 $30,000 $30,000
Cash distribution (50,000) (10,000) (10,000)
Gain recognized 20, N/A N/A
Basis after cash , ,000
A/R distrib N/A
Loss recognized N/A (20,000) N/A
Basis after A/R ,000
Filing cabinet N/A N/A (20,000)
Ending basis $ $ $ -0-

21. Proportionate Liquidating Distribution Examples (slide 3 of 4)
G H I
Basis in p'ship int. $ $ $ -0-
Basis in cash 50, ,000 10,000
Basis in A/R N/A
Basis in filing cabinet N/A N/A 20,000
Capital (Gain)/loss (20,000) 20, N/A
Original basis $30,000 $30,000 $30,000

22. Proportionate Liquidating Distribution Examples (slide 4 of 4)
Sale of non-cash assets at FMV:
Example H: A/R Fil.Cab. Total
Selling price $16,000 N/A $16,000
Basis N/A
Gain/(loss) $16,000 N/A $16,000 (Ordinary)
Example I:
Selling price $16, $ $16,300
Basis , ,000
Gain/(loss) $16, ($19,700) ($3,700) (Ordinary) (May be ord)

23. Property Distributions with Special Tax Treatment (slide 1 of 4)
Disguised sales
Contribution of appreciated property to partnership followed by a cash distribution to the contributing party may be treated as a disguised sale
Treated as a sale of property resulting in gain recognition
Partnership’s basis in the asset is cost

24. Property Distributions with Special Tax Treatment (slide 2 of 4)
Marketable securities
FMV of marketable securities distributed to a partner is treated as a cash distribution
Any excess of FMV of securities distributed over partner’s outside basis is taxable gain
Marketable securities include most actively traded debt or equity interests, options, futures, and derivatives
Exceptions apply

25. Property Distributions with Special Tax Treatment (slide 3 of 4)
Precontribution gain property
Contributing partner recognizes gain on distribution of precontribution gain property in two situations:
1. If property is distributed to another partner within 7 years of contribution date, contributing partner recognizes remaining precontribution gain
Partner’s basis in partnership and basis of distributed property is increased by gain recognized

26. Property Distributions with Special Tax Treatment (slide 4 of 4)
Precontribution gain property
Contributing partner recognizes gain on distribution of precontribution gain property in two situations (cont’d):
2. If partnership distributes ANY property other than cash to a partner within 7 years after THAT partner contributes appreciated property, the partner recognizes the lesser of:
Remaining net precontribution gain
Excess of FMV of distributed property over partner’s basis in partnership interest

27. Disproportionate Distributions (slide 1 of 3)
Occur when partnership distributes cash or property to a partner which increases or decreases the partner’s share of ordinary income-producing assets (hot assets)

28. Disproportionate Distributions (slide 2 of 3)
If partner receives less than proportionate share of hot assets, then treated as if:
Partnership distributed some of the assets, and
Partner sold these hot assets back to partnership
Partner recognizes ordinary income on sale of the hot assets; Partnership’s basis in hot assets is cost

29. Disproportionate Distributions (slide 3 of 3)
Hot assets include:
Substantially appreciated Inventory
Inventory includes all assets other than cash, capital and §1231 assets
Substantially appreciated means FMV > 120% of partnership’s adjusted basis in inventory
Unrealized receivables
Rights to receive future amounts that will result in ordinary income recognition

30. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 1 of 3)
§736(a) income payment:
Treated as distributive share of partnership income or guaranteed payment to partner
Certain items if partnership is service-provider and retiring partner is a general partner:
Unrealized receivables (except depreciation recapture)
Goodwill (unless provided for in partnership agreement)
§736(b) property payment:
Payments made for liquidated partner’s share of partnership’s assets

31. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 2 of 3)
§736(a) income payment:
Partner has:
Ordinary income (guaranteed payment), or
Distributive share of income
Partnership has:
Guaranteed payment (deductible) if determined without regard to partnership profits
Distributive share if based on profits

32. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 3 of 3)
§736(b) property payment:
Disproportionate distribution to extent of partner’s share of hot assets
Return of basis (and capital gain (loss) for remainder)

33. Sale Of Partnership Interest (slide 1 of 4)
Generally, results in gain or loss recognition by selling partner
Gain(loss) = amount realized less partner’s basis in partnership interest
Partnership liabilities assumed by purchasing partner are treated as part of consideration paid for the partnership interest

34. Sale Of Partnership Interest (slide 2 of 4)
Partnership tax year closes for that partner on sale date
Partner’s share of income through sale date is calculated
Can prorate annual income or use interim closing of the books
Taxed to selling partner and increases basis in partnership interest

35. Sale Of Partnership Interest (slide 3 of 4)
Effect of hot assets
Hot assets include:
Unrealized receivables (same as for disproportionate distributions)
Inventory
Includes all partnership property except money, capital assets, and §1231 assets

36. Sale Of Partnership Interest (slide 4 of 4)
Effect of hot assets (cont’d)
Must allocate sales price of partnership interest between “hot” (ordinary income) assets and “nonhot” (capital gain) components
Selling partner’s gain is classified as a capital gain or loss portion and an ordinary income or loss amount related to the hot assets

37. Other Dispositions of Partnership Interests (slide 1 of 8)
Transfer of a partnership interest to a controlled corporation
Tax free if §351 requirements are met
If 50% or more of the total interest in capital and profits of the partnership are transferred, the partnership terminates

38. Other Dispositions of Partnership Interests (slide 2 of 8)
Incorporating a partnership
At least three methods available:
1.Transfer each partner’s interest to the corp in exchange for stock
Partnership terminates
Corp becomes owner of all partnership assets
Corp has substituted basis in assets; Old partners have substituted basis in stock

39. Other Dispositions of Partnership Interests (slide 3 of 8)
Incorporating a partnership (cont’d)
2. Transfer partnership assets to corp in exchange for stock and assumption of partnership liabilities
Partnership distributes stock to partners in liquidating distribution
Corp has carryover basis in assets; Old partners have substituted basis in stock

40. Other Dispositions of Partnership Interests (slide 4 of 8)
Incorporating a partnership (cont’d)
3. Partnership distributes all assets and liabilities pro rata to partners in complete liquidation of partnership
Partners transfer assets and liabilities to corp in exchange for stock under §351
Corp has substituted basis for assets; Partners have substituted basis for stock

41. Other Dispositions of Partnership Interests (slide 5 of 8)
Incorporating a partnership (cont’d)
All three methods of incorporating a partnership are tax-free
Exception: if liabilities of partnership exceed basis of transferred assets

42. Other Dispositions of Partnership Interests (slide 6 of 8)
Nontaxable like-kind exchange rules do not apply to the exchange of interests in different partnerships

43. Other Dispositions of Partnership Interests (slide 7 of 8)
Generally, the gift of a partnership interest is tax-free
Partnership income, loss, etc. is prorated between donor and donee

44. Other Dispositions of Partnership Interests (slide 8 of 8)
Death of a partner
Taxable year of partnership closes with respect to that partner on date of death
Compute deceased partner’s share of partnership income or loss to that date and report on partner’s final Form 1040

45. §754 Election Adjusts partnership’s basis in assets to reflect:
The amount paid by the purchasing partner in excess of his share of the inside basis of partnership assets
Gain or loss recognized by partner receiving distribution from partnership
Once made, election remains in effect for all future years unless election revoked with IRS consent

46. Termination of Partnership (slide 1 of 3)
Partnership terminates when either of the following events occur:
No part of the business continues to be carried on by any partners
Within a 12-month period, 50% or more of the partnership’s capital and profits interests are sold or exchanged

47. Termination of Partnership (slide 2 of 3)
Partnership tax year closes when:
The partnership incorporates
One partner in a two-party partnership buys out the other partner

48. Termination of Partnership (slide 3 of 3)
Partnership tax year usually does not close:
Upon the death of a partner
Entry of a new partner
Liquidation of a partner in other than a two-party partnership
Sale or exchange of a less than 50% partnership interest

49. Family Partnerships (slide 1 of 3)
Owned and controlled primarily by members of the same family
Often formed to save taxes by funneling some of parent’s income to the children
Often difficult to establish for tax purpose

50. Family Partnerships (slide 2 of 3)
Family member will be recognized as a partner if:
Capital is a material income-producing factor and partnership interest is acquired in a bona fide transaction where ownership and control are received
Can be acquired by gift or purchase from another family member
Capital is not a material income-producing factor, but family member contributes substantial or vital services

51. Family Partnerships (slide 3 of 3)
Kiddy tax may apply to child partner under age 14 and claimed as a dependent by parent-partner
Family member whose interest is acquired by gift from another family member may only have a portion of partnership income allocated to them
Donor partner must be allocated income representing reasonable compensation for services rendered to the partnership

52. Limited Liability Companies
A LLC with 2 or more owners is taxed as a partnership
LLC members are not personally liable for debts of the entity
Effectively treated as a limited partnership with no general partners
LLCs are relatively new so there is no established body of case law available
Makes planning difficult

53. Limited Liability Partnerships
Partners are not personally liable for the malpractice and torts of their partners
Taxable as a partnership
Conversion of a general partnership into a LLP is not taxable if all of the general partners become LLP partners and hold the same proportionate interest

54. Donald R. Trippeer – trippeerd@mail.ecu.edu East Carolina University
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East Carolina University