Current and Liquidating Distributions

[Pages:28]Current and Liquidating Distributions

OVERVIEW

The basic principle underlying the tax treatment of partnership distributions is that the distribution should be tax free to the partnership and to the distributee partner if possible. Therefore, non- liquidating distributions of property are always tax free, and the asset's basis in the hands of the partnership carries over into the hands of the distributee-partner if her outside basis can absorb it. Likewise, non- liquidating cash distributions are tax free, except to the extent the amount of cash exceeds the distributee partner's outside basis.

Non-liquidating distributions, unlike liquidating distributions, are distributions that do not result in the termination of a partner's entire interest in a partnership. Partial liquidation of a partner's interest and distributions of a partner's distributive share are, therefore, considered nonliquidating distributions.

Generally, there is no recognized gain or loss on non-liquidating distributions, unless a cash distribution exceeds the distributee partner's outside basis. Instead, the distributee partner:

(1) Assumes the partnership's adjusted basis in any distributed non-cash property; (Code Section 732(a)(1) ) and

(2) reduces his outside basis (but not below zero) by the amount of cash distributed and the allocated basis of distributed property.

If the reduction of a partner's outside basis disturbs the balance between aggregate outside basis and aggregate inside basis, the partnership may elect to adjust the basis of partnership property to reestablish the balance.

This tax deferral scheme, however, is nullified if the distribution involves "unrealized receivables" or "inventory items which have appreciated substantially." Code Section 751(b). If these assets are transferred between a partner and the partnership, the transaction is treated as a sale and exchange of property and subject to taxation.

DISTRIBUTIONS NOT SUBJECT TO CODE SECTION 751(b)

(a) BASIC TAXATION RULES

(a)(1) Recognition of gain and loss

The basic principle underlying the tax treatment of partnership distributions is that a distribution should be tax free to the partnership and to the distributee partner, if possible. Loss is not recognized on a non-liquidating distribution, and gain is generally recognized by the distributee partner only to the extent that the amount of cash distributed exceeds the distributee partner's predistribution outside basis. This is consistent with the basic principle underlying partnership taxation that transactions between a partner and the partnership should not be taxable. Instead, taxation generally waits until the partnership or one of its partners engages in a transaction with someone outside the partnership.

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OBSERVATION: A draw or advance against partnership share is not treated as a partnership distribution until the last day of the partnership taxable year. At least one group of commentators has interpreted this rule to mean that the tax consequences of all partnership distributions are determined as of the close of the partnership taxable year, thereby permitting the partners to use the current year's income to absorb distributed cash. However, such a reading of Reg. Section 1.731-1(a)(1)(ii) seems inconsistent with the statute and the IRS's approach on this issue.

(a)(2) Basis of distributed property and outside basis

Most distributions described in Code Section 731(a) are tax free and have no net effect on the distributee partner's overall basis. Code Section 732 provides that the distributee partner carries over the partnership's adjusted basis in the distributed assets, and whatever basis is so allocated to the distributed property is subtracted from the distributee partner's outside basis under Code Section 733. Accordingly, a tax-free distribution under Code Section 731 essentially reallocates the distributee partner's pre-distribution outside basis between the distributed property and the partner's post- distribution outside basis. Of course, to the extent the distribution includes cash as well as property, the distributee partner's outside basis is first reduced by the amount of the cash distributed. Code Section 733(1).

If, however, the distributee partner's pre-distribution outside basis is less than the partnership's basis in the distributed assets, the partner's outside basis drops to zero, and his entire pre-distribution outside basis is allocated to the distributed property. Once again, if the distribution includes cash as well as property, the partner's pre- distribution outside basis is first used to absorb the cash, and only the excess is allocated to the distributed property. Code Section 733(1).

EXAMPLE 1: A is a member of the ABC partnership. ABC distributescash of $7,000 and inventory with an adjusted basis of $8,000 and a fair market value of $10,000 to A. At the time of the distribution, A's outside basis equals $15,000. Since the cash distributed does not exceed his pre-distribution outside basis, there is no gain on the distribution. Code Section 731(a)(1). Under Code Section 732(a), A's basis in the distributed property equals $8,000 (i.e., pre-distribution outside basis of $15,000 minus the $7,000 cash distributed). A's outside basis is reduced to $0 (i.e., pre-distribution outside basis of $15,000 minus the $7,000 cash distributed minus the $8,000 basis in the distributed property). Code Section 733.

When allocating the partner's pre-distribution outside basis to distributed assets under Code Section 732(a)(2), ordinary income assets (i.e., unrealized receivable and inventory) are given a carryover basis before any basis is given to capital assets. Code Section 732(c)(1). This minimizes the likelihood that a distribution will increase the amount of ordinary income recognized upon disposition of the distributed assets.

EXAMPLE 2: N is a member of the MNO partnership. MNO distributes cash of $7,000, inventory with adjusted basis of $6,000 and fair market value of $10,000, and a capital asset with adjusted basis of $24,000 and fair market value of $29,000 to N. At the time of the

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distribution, N's outside basis equals $32,000. Because the cash distributed does not exceed his pre-distribution outside basis, there is no gain on the distribution. Code Section 731(a)(1). Under Code Section 732(a)(2), N's basis in the distributed assets equals $25,000 (i.e., pre-distribution outside basis of $32,000 less the $7,000 cash distributed). Of that $25,000 basis, $6,000 is first allocated to the inventory pursuant to Code Section 732(c)(1)(A)(i), and the remaining $19,000 is allocated to the capital asset under Code Section 732(c)(1)(B). N's outside basis is reduced to $0 under Code Section 733.

If the combined carryover basis for the distributed ordinary income assets exceeds the partner's outside basis (reduced by any cash received in the distribution), a three-step process is used to decrease the bases of the distributed assets to a point where their aggregate basis equals the partner's outside basis:

(1) Determine the total amount of basis decrease necessary;

(2) reduce the basis of the distributed assets having unrealized loss, but only to the extent of the loss; and Code Section732(c)(3)(A)

(3) finally, allocate any remaining basis decrease to the distributed assets in proportion to their adjusted bases (as adjusted under Step 2). Code Section 732(c)(3)(B).

EXAMPLE 3: C is a member of the CDE partnership. CDE distributes cash of $10,000, unrealized receivables with an adjusted basis of $8,000 and fair market value of $6,000, and inventory with an adjusted basis of $24,000 and fair market value of $33,000 to C. At the time of the distribution, C's outside basis equals $35,000. Because the cash distributed does not exceed her pre-distribution outside basis, there is no gain on the distribution. Code Section 731(a)(1). Under Code

Section 732(a)(2), C's basis in the distributed assets equals $25,000 (i.e., pre-distribution outside basis of $35,000 less the $10,000 cash distributed). Since the aggregate basis of the ordinary income assets is $32,000, the amount of asset basis decrease necessary is $7,000 ($32,000 minus $25,000). The unrealized receivable carries an unrealized loss of $2,000 ($8,000 minus $6,000), so its basis will first be decreased by that amount (for an adjusted basis of $6,000). This leaves $5,000 of additional necessary basis decrease ($7,000 minus $2,000), of which $1,000 is allocated to the unrealized receivable ($6,000/$30,000 x $5,000) and $4,000 is allocated to the inventory ($24,000/$30,000 x $5,000). Therefore, C's outside basis is reduced to $0 under Code Section 733, her basis in the unrealized receivable is $5,000 ($6,000 minus $1,000), and her basis in the inventory is $20,000 ($24,000 minus $4,000).

After allocating the distributee partner's outside basis to ordinary income assets, or if there are no such assets, the same three-step process described above is used to allocate distributed capital assets. Code Section 732(c)(1)(B).

EXAMPLE 4: R is a member of the QRS partnership. QRS distributes cash of $7,000, capital asset A with an adjusted basis of $6,000 and fair market value of $10,000, and capital asset B with an adjusted basis of $24,000 and fair market value of $29,000 to R. At the time of the

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distribution, R's outside basis equals $32,000. Because the cash distributed does not exceed his pre-distribution outside basis, there is no gain on the distribution. Code Section 731(a)(1). Under Code

Section 732(a)(2), R's basis in the distributed assets equals $25,000 (i.e., pre-distribution outside basis of $32,000 less the $7,000 cash distributed). Since both assets are capital assets, there is no allocation under Code Section 732(c)(1)(A). Since the aggregate basis of the capital assets is $30,000, the amount of asset basis decrease necessary is $5,000 ($30,000 minus $25,000). Neither capital asset carries an unrealized loss; therefore, no initial basis adjustment is necessary. Capital asset A's basis is reduced by $1,000 ($6,000/$30,000 x $5,000) and capital asset B's basis is reduced by $4,000 ($24,000/$30,000 x $5,000). Therefore, R's outside basis is reduced to $0 under Code Section 733, his basis in capital asset A is $5,000 ($6,000 minus $1,000), and his basis in capital asset B is $20,000 ($24,000 minus $4,000).

(b) DISTRIBUTION AND CAPITAL ACCOUNTS

Capital accounts measure a partner's share of the partnership's book income and generally move up and down with a partner's outside basis (excluding the effect of partnership debt on outside basis). Therefore, as distributions of cash or property reduce a distributee partner's outside basis, (Code Section 733 ) her capital account is also decreased. However, the amount of the capital account adjustment is somewhat different from the outside basis adjustment. While outside basis decreases (which cannot result in a negative basis) are based upon the amount of money or basis of property distributed, (Code Section 733 ) capital account reductions (which can result in a negative balance) are based upon the fair market value of distributed property and the allocation of unrealized appreciation or loss among all the partners. Reg. Section 1.7041(b)(2)(iv)(e)(1).

The first step in determining capital account adjustments following a distribution of property is to adjust each individual partner's capital account as if the distributed property had been sold for fair market value. This requires a hypothetical allocation of gain or loss among the partners. After these initial account adjustments have been made, the distributee partner's capital account is decreased by the fair market value of the distributed property. Reg. Section 1.704- 1(b)(2)(iv)(e)(1).

EXAMPLE 5: P and Q are equal partners in the PQ partnership, each having a capital account and outside basis of $8,000. PQ distributes Blackacre to P. Blackacre has an adjusted basis and book value in the hands of the partnership of $6,000 and a current fair market value of $16,000. The partners have also agreed to allocate gain from the disposition of Blackacre 60 percent to P and 40 percent to Q. The effect of the distribution on the partners' capital accounts is:

P ------$ 8,000

6,000

(16,000) ------($ 2,000) =======

Q ------$ 8,000

4,000

0 -----$12,000 ======

Initial balance Unrealized book appreciation in Blackacre Fair market value of Blackacre

Totals

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When an asset is revalued incident to a distribution, it is the unrealized book gain or loss, not the unrealized tax gain or loss, that must be allocated among the partners. Reg. Section 1.704-1(b)(2)(iv)(e)(1). This, inter alia, ensures that any pre- contribution appreciation that has not been realized for tax purposes is not entered into a capital account twice.

EXAMPLE 6: J and K form a general partnership by J contributing cash of $10,000 and K contributing non-depreciable property with adjusted basis of $7,000 and fair market value of $10,000 (this property is "booked-in" at $10,000 so that K's capital account is credited with $3,000 of appreciation). J and K agree to allocate all gain and loss equally except as otherwise required under Code Section 704(c). If

the property contributed by K is subsequently distributed to J when it has a fair market value of $12,000 (and ignoring the impact of Code Section 704(c)(1)(B)) , the capital accounts will be:

J --------

$10,000 1,000

( 12,000) -------

($ 1,000) =======

K -------$10,000 Initial contributions

1,000 Book unrealized appreciation 0 Fair market value of property

-----$11,000 Totals

======

If any unrealized appreciation or loss in the distributed property is allocable to non-distributee partners, a book/tax disparity for both the distributee and non-distributee partners in equal, but opposite, amounts is created (assuming the distributee partner's outside basis is sufficient to absorb the distributed property's basis). There is, however, no net partnership book/tax disparity by reason of the distribution because the partners' book/tax disparities cancel each other out so that aggregate capital accounts continue to equal aggregate outside bases.

EXAMPLE 7: A and B are equal partners in the AB Partnership. A capital asset having an adjusted basis and book value of $6,000 and fair market value of $16,000 is distributed to A. At the time of the distribution, each partner has a capital account and outside basis of $8,000. The partners agree to allocate gain from disposition of the distributed property 60 percent to A and 40 percent to B. As a result of the distribution, the partnership's books become:

A

Capital Outside

Account

Basis

------- -------

$ 8,000 $ 8,000

6,000

0

( 16,000) ------

($ 2,000) ======

( 6,000) -----

$ 2,000 ======

B Capital Account ------$ 8,000

4,000

0 ----$12,000 ======

Outside Basis

-------$ 8,000

0

0 ----$ 8,000 ======

Formation Revaluation of asset Distribution

Totals

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If the distributee partner is allocated the entire unrealized gain or loss in the distributed property, book/tax disparities will not be created (again, assuming the distributee partner's outside basis can absorb the distributed property's basis).

EXAMPLE 8: V and W are equal partners in the VW Partnership, each having a capital account and outside basis of $32,000. Greenacre is distributed to V when Greenacre has an adjusted basis and book value in the hands of the partnership of $22,000 and a current fair market value of $26,000. The partners have agreed that all unrealized appreciation in Greenacre will be allocated to V. As a result of the distribution, the partnership's books become:

V

Capital Outside

Account Basis

------- -------

$ 32,000 $ 32,000

4,000

0

W

Capital Outside

Account Basis

------- --------

$ 32,000 $ 32,000

0

0

( 26,000) ( 22,000)

0

------ ------ ------

$ 10,000 $ 10,000 $ 32,000

======= ======= =======

0 -----$ 32,000 =======

Formation Unrealized book appreciation Distribution

Totals

If the distributee partner's outside basis is not large enough to absorb the amount of cash or basis of property distributed, her capital account is still reduced by the full amount of the distribution, even if outside basis is reduced by less under the "not below zero" language of Code Section 733. Reg. Section 1.704-1(b)(2)(iv)(b). Book/tax disparities are thereby created for the distributee partner and the partnership as a whole.

EXAMPLE 9: E and B are equal partners in the EB Partnership. E receives a cash distribution of $10,000 from the partnership when both partners have an outside basis and capital account of only $8,000. Under Code Section 731(a)(1), E recognizes income of $2,000. E also reduces his outside basis by the amount of cash distributed, but not below zero under Code Section 733(1)

(i.e., he reduces his outside basis by $8,000) However, E's capital account is reduced by the full amount of the distribution, leaving his capital account at negative $2,000. This also creates a net book/tax disparity because the aggregate outside basis ($8,000) is no longer equal to the aggregate capital accounts ($6,000). Following the distribution, the partnership's books become:

E

Capital Outside

Account

Basis

------- -------

$ 8,000 $ 8,000

( 10,000) ( 8,000)

------

-----

($ 2,000) $

0

====== ======

B

Capital Outside

Account Basis

------- --------

$ 8,000 $ 8,000

0

0

-----

-----

$ 8,000 $ 8,000

====== ======

Formation Distribution

Totals

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OBSERVATION: The book/tax disparities caused by revaluations of distributed assets (e.g., Example 7) must, under Code Section 704(b), be addressed in accordance with Code Section 704(c) (concerning tax consequences among partners with respect to pre-contribution gain and loss). Reg. Section 1.7041(b)(2)(iv)(g). However, some distributions of property can cause book/tax disparities unrelated to revaluations of partnership assets (e.g., where the distributee partner's outside basis is not able to absorb the amount of cash or basis of property distributed). These book/tax disparities are permanent and cannot be eliminated with curative or remedial allocations because there is no offsetting book/tax disparity for some other partner. Only the liquidation of the distributee partner's interest in the partnership will resolve these disparities.

(c) DISTRIBUTIONS OF ENCUMBERED PROPERTY

When encumbered property is distributed by a partnership, the debt allocation rules of Code Section 752 are triggered. As to the non-distributee partners, the effect is a constructive distribution to each partner equal to the partner's share of debt eliminated. Code Section 752(b). As to the distributee partner, though, the effect is two-fold:

(1) He loses his share of the debt as a partner and is credited with

a constructive distribution under Code Section 752(b) ;

but

(2) acquires the entire debt as an individual, which is treated as a contribution of money to the partnership under Code Section 752(a).

These two effects are netted to produce a single, net increase in the share of debt. When two or more partnerships merge or consolidate using the Assets-Over form described in Reg. Section 1.708-1(c)(3)(i), increases and decreases in partnership liabilities associated with the merger or consolidation are netted by the partners in the terminating partnership and the resulting partnership to determine the effect of the merger under Code Section 752.

Since constructive distributions resulting from the decrease in a partner's share liability are non-liquidating distributions, they are treated in accordance with Code Sections 731, 732, and 733. In addition, the partners' capital accounts must be adjusted in light of all distributions.

EXAMPLE 10: K and L are equal members of the KL partnership, with each partner having a capital account of $10,000 and an outside basis of $13,000. The partnership distributes Whiteacre to K. Whiteacre has an adjusted basis and fair market value of $8,000 and is subject to a debt of $6,000. Prior to the distribution, each partner shared one-half of the partnership's $6,000 debt. After the distribution, the partnership debt is gone. However, the debt is now entirely allocable to K because K now owns the encumbered property.

The distribution reduces L's share of the liability from $3,000 to $0 and increases K's share of the liability from $3,000 to $6,000. Applying Code Section 752(b) to L and Code Section 752(a) to K, this liability shift decreases L's outside basis by $3,000 (under Code Section 733 ) and increase K's outside basis by the same amount (under Code Section 722 ). Note that

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the changes in shares of partnership liability have no effect on the partners' capital accounts.

Since the constructive distributions are non-liquidating distributions, no gain or loss is recognized. Code Section 731(a).

K takes the property with a carryover basis of $8,000 (Code Section 732(a)(1) ) and reduces his outside basis by the same amount. Code Section 733(2).

K finally reduces his capital account by the $2,000 fair market value of the property distributed net of liabilities. Reg. Section 1.7041(b)(2)(iv)(b). To summarize:

K

Capital Outside

Account Basis

------- -------

$10,000 $13,000

0

3,000

0 ( 8,000)

( 2,000)

0

------- -------

$ 8,000 $ 8,000

======= =======

L

Capital Outside

Account Basis

------- -------

$10,000 $13,000

( 3,000)

0

0

0

0

0

------- -------

$10,000 $10,000

======= =======

Start Code Section 752 Code Section 733(2) Net distribution

Ending balances

(d) DISTRIBUTION OF MARKETABLE SECURITIES

Under Code Section 731(c)(1)(A), a distribution of marketable securities is taxed as a distribution of cash rather than as a distribution of property. As a result, gain will be recognized if the value of the securities (plus any cash actually distributed) exceeds the distributee partner's pre-distribution outside basis.

EXAMPLE 11: B and L form the BL Partnership as equal partners. B contributes property with a fair market value of $1,000 and an adjusted basis of $300. L contributes $1,000 cash. BL subsequently purchases Security Z for $500 and immediately distributes the security to B. At the time of the distribution, B's outside basis is $300. The distribution of Security Z is treated as a $500 (fair market value of Security Z) distribution of money under Code Section 731(c)(1). As a result, B recognizes $200 of gain under Code Section 731(a)(1), because the constructive cash distribution ($500) exceeded his outside basis ($300) by that amount.

For purposes of Code Section 731(c), the term "marketable securities" includes:

(1) Financial instruments (e.g., stocks and other equity interests, bonds and other evidences of indebtedness, options, forward or futures contracts, notional principal contracts, and derivatives) that are actively traded, convertible into (or exchangeable for) money or other marketable securities, or valued substantially by reference to other marketable securities;

(2) foreign currencies that are actively trades;

(3) interests in a common trust fund or regulated investment company which is offering for sale or has outstanding any redeemable security;

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