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

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

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

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

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

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

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

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

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

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 $15,000 $ 5,000 Land - basis N/A $ 6,000 N/A (Fair mkt value) N/A $10,000 N/A Accts rec -basis N/A N/A -0- (Fair mkt value) N/A N/A $16,000

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

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 5,000 Basis in land N/A 6,000 N/A Basis in A/R N/A N/A -0- 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

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 40,000 N/A Land -basis N/A N/A $30,000 (Fair mkt value) N/A N/A $50,000

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 10,000 10,000 N/A Basis after cash (and deemed cash) dist. -0- -0- 10,000 Land distrib. N/A N/A (10,000) Basis after all distrib. -0- -0- -0-

Proportionate Nonliquidating Distribution Examples (slide 6 of 6) D E F Basis in p'ship int. -0- -0- -0- Basis in cash 40,000 N/A 20,000 Liabilities relieved N/A 40,000 N/A Basis in land N/A N/A 10,000 Gain recognized (10,000) (10,000) N/A Original basis 30,000 30,000 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

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

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

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

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 -0- -0- (Fair mkt value) N/A $16,000 $16,000 Filing cabinet (1231) N/A N/A 300 (Fair mkt value) N/A N/A 300

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 20,000 N/A N/A Basis after cash -0- 20,000 20,000 A/R distrib. N/A -0- -0- Loss recognized N/A (20,000) N/A Basis after A/R -0- -0- 20,000 Filing cabinet N/A N/A (20,000) Ending basis $ -0- $ -0- $ -0-

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

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 -0- N/A -0- Gain/(loss) $16,000 N/A $16,000 (Ordinary) Example I: Selling price $16,000 $ 300 $16,300 Basis -0- 20,000 20,000 Gain/(loss) $16,000 ($19,700) ($3,700) (Ordinary) (May be ord)

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

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

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

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

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)

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

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

§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

§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

§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)

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

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

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

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

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

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

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

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

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

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

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

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

§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

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

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

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

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

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

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

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

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

Donald R. Trippeer – trippeerd@mail.ecu.edu East Carolina University If you have any comments or suggestions concerning this PowerPoint Presentation, please contact: Donald R. Trippeer – trippeerd@mail.ecu.edu East Carolina University