The IRS has updated its practice unit on liquidating distributions of a partners interest in a partnership. The overview is as follows:
All partnership distributions are either current or liquidating. A liquidating distribution terminates a partner’s entire interest in the partnership. A current distribution reduces a partner’s capital accounts and basis in his interest in the partnership (“outside basis”) but does not terminate the interest.
For current and liquidating distributions, a partner will generally not recognize gain. IRC 731(a)(1). However, gain may be recognized on the distribution of assets such as IRC 751(b) “hot” assets (inventory or unrealized receivables). IRC 751 gain arising from a distribution is treated as gain from the sale or exchange of a partnership interest and thus is generally capital gain, unless IRC 751 is applicable. IRC 741.
For current distributions, a partner recognizes gain to the extent the money he receives is greater than his outside basis immediately before the distribution. IRC 731(a)(1). A reduction of a partner’s share of the partnership’s liability is treated as a distribution of money under IRC 752(b) and distributions of marketable securities may also be treated as money under IRC 731(c). A partner will never recognize a loss on a current distribution. IRC 731(a)(2).
For liquidating distributions, gain is recognized to the extent money (or deemed money) distributed exceeds the partner’s outside basis; loss is recognized to the extent the partner’s outside basis exceeds money distributed and the basis of any hot assets distributed. A partner will not recognize a loss on a liquidating distribution if he receives any property other than money, unrealized receivables, or inventory.
Outside basis is the partner’s tax basis in the partnership interest. IRC 705(a). Inside basis is the partnership’s tax basis in partnership assets. In general, Subchapter K attempts to keep inside basis equal to the sum of each partner’s outside basis, so a change in the partnership’s inside basis is typically reflected by a corresponding change to one or more of the partners’ outside bases. However, inside basis may not equal the sum of the partners’ outside basis if the partnership does not have an IRC 754 election in place and one or more of the following transactions took place: 1) a partnership interest is acquired at fair market value (sale or exchange), 2) there is a basis adjustment due to the death of a partner, and 3) there is a distribution resulting in recognized gain or loss for the partner, or there is a distribution resulting in an increase or decrease in the basis of a partnership asset (excluding the application of IRC 732(d)).
In a liquidating distribution, the outside basis of the distributee partner must be allocated to all of the assets received in the distribution. Basis is always allocated first to money. The basis allocated to the other property distributed to a partner is generally a carryover basis from the partnership’s inside basis. IRC 732(a). However, in the event there is insufficient outside basis to give each asset a carryover basis, the shortfall must be allocated. IRC 732(c). That shortfall is first allocated to the assets other than unrealized receivables and inventory. If those assets’ bases are reduced to zero, then the shortfall is allocated to the unrealized receivables and inventory reducing their bases.
In the event the partner’s outside basis exceeds the basis necessary to give a carryover basis, then the basis of the assets other than unrealized receivables and inventory is increased. The bases of hot assets distributed to a partner are always limited to the basis the partnership had in those assets prior to the distribution. Treas. Reg. 1.732-1(c)(1). If the distribution consists only of money, unrealized receivables, and inventory, then the partner recognizes a loss. The rules of allocation among assets are explained in more detail in the examples.
Following a distribution where a partner recognizes gain or loss or the basis of distributed assets is adjusted from their carryover basis, an inside/outside basis disparity is created. Subchapter K resolves this disparity by permitting an adjustment to the assets remaining in the partnership. IRC 734. The adjustments are made only if the partnership has an IRC 754 election or if the distribution resulted in a substantial basis reduction (that is, the sum of the loss recognized and basis reduction were more than $250,000).
In the event that the distributee partner recognizes gain or his outside basis was insufficient to give a transferred basis to all of the assets, then IRC 734(b)(1) provides an offsetting basis increase to the assets remaining in the partnership equal to the gain recognized plus the basis shortfall. In the event the distributee partner recognizes loss or his outside basis exceeds the basis necessary to give a carryover basis, then IRC 734(b)(2) provides a basis decrease to the assets remaining in the partnership equal to the loss recognized plus excess basis. The allocation of IRC 734 adjustments among the partnership’s assets is covered by IRC 755.
Generally, gain recognized upon a sale of hot assets following a distribution will be ordinary. IRC 735. However, in the case of inventory, if it is sold five years after the distribution, then the character of the gain is determined at the partner level.
All liquidating payments to a retiring partner or a deceased partner’s successor in interest are classified as either IRC 736(a) or IRC 736(b) payments. If the payments are made as liquidating distributions for a partnership interest, they are IRC 736(b) payments and treated as received under the distribution rules set forth in IRC 731 and 732. If the payments are for a distributive share of the partnership income or guaranteed payments, they are IRC 736(a) payments. This Practice Unit does not cover these types of payments.
A partner’s entire interest may be terminated through a single distribution or a series of distributions. Treas. Reg. 1.761-1(d)(1) provides that the series of distributions might occur over more than a one-year period if there is a clear plan that the distributions are being made toward the termination of the partner’s entire interest in the partnership. A partner receiving a series of liquidating distributions will recognize gain only when the aggregate cash distributions exceed the partner’s basis in his interest.
This Practice Unit discusses distributions in liquidation of a partnership interest. There are exceptions to the regular distribution rules under IRC 731 and 732(b) which are not covered in this Practice Unit. IRC 704(c)(1)(B) states that if a partner contributes appreciated or depreciated property to a partnership and if the partnership distributes such property to a partner other than to the original contributor within seven years, then the contributor partner may have to recognize gain or loss. Similarly, IRC 737 provides that if a partner who contributed property to a partnership receives a distribution of property other than money from a partnership, the partner recognizes gain but not loss equal to the lesser of: (1) the excess of the property’s value over the partner’s outside basis (reduced by any money distributed) or (2) the partner’s net pre-contribution gain. Neither IRC 704(c) nor IRC 737 are covered in this Practice Unit.
In addition, this Practice Unit does not discuss in detail distributions that may be disguised sales under IRC 707.
This Practice Unit covers the computation of gain or loss from liquidating distributions of a partnership interest consisting of cash, property, or a combination of assets including cash and property. All scenarios and examples discussed are for proportionate distributions where the distributee partner receives his proportionate share of ordinary income generating assets. A distribution is disproportionate if a partner receives more or less than his pro rata share of IRC 751(b) “hot” assets.
Posted by Lewis J. Saret, Co-General Editor, Wealth Strategies Journal..