125,970 views | Jan 20, 2015, 08:29am

Tax Geek Tuesday: Understanding

Partnership Distributions, Part 1
Tony Ni i Senior Contributor
Taxes

This article is more than 2 years old.

It's been eons since we've had a Tax Geek Tuesday, but that's not to say I've shirked my
responsibility of trying to make sense of the nether regions of the Internal Revenue Code.
For the past few months, I've been traveling around the country teaching the finer points
of the Affordable Care Act and the repair regulations in such exotic locales as Hartford,
Grand Junction and Billings, which is every bit as depressing as it sounds.

But now that I'm settled in, I'm excited to get back to providing what no one ever really
asked for: an in-depth look at a narrow area of the tax law.

Today's topic is partnership distributions. As you will see, the regime governing
partnership distributions is drastically different from the one governing corporate
distributions. This is primarily attributable to the fact that when a corporation (whether C
or S) makes a distribution of appreciated property, the corporation recognizes gain as if it
sold the asset for its FMV. To the contrary, when a partnership distributes appreciated
property, the general rule is one of deferral; i.e, no gain is recognized by the partnership,
and instead the gain will be recognized when the distributee partner sells the property.

The downside of deferral, however, is that in order to ensure that any gain in the
partnership's assets is preserved, a complex set of rules governing the distributee partner's
basis in the distributed property is required.

It is these rules -- those governing gain recognition and determination of partner basis --
that are the focus of this Tax Geek Tuesday. Next week, we'll address a slightly more
nuanced issue -- the so-called "mixing bowl" rules of Sections 737 and 704.
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Let's get started.

Today In: Investing

Partnership Distributions, Part 1: Gain/Loss and Basis Issues

The primary Code sections that govern the treatment of partnership distributions are
Section 731, Section 732, and Section 733, which determine the amount of gain or loss
recognized by the partner, his basis in the distributed property, and the effect of the
distribution on his basis in his partnership interest. The tax treatment of a distribution,
however, depends on whether it is a current distribution or a liquidating distribution.

Current Distributions

A current distribution is a distribution that does not terminate a partner’s interest in the
partnership. If, however, a distribution is part of a series of distributions that will result in
the termination of the partner’s interest, the distribution is not a current distribution.
Thus, current distributions include both distributions of a partner’s distributive share of
partnership income as well as distributions in partial liquidation of a partner’s interest
(i.e., distributions that are a return of a partner’s investment in the partnership).

Ex: A is a 50% partner in partnership AB. AB distributes cash of $20,000 to A, and A’s
ownership decreases from 50% to 30%. The distribution of $20,000 is treated as a
current distribution because it is not part of a series of distributions that will result in the
termination of A’s interest.

Gain Recognition: Section 731

Under Section 731(b), a partnership that makes a current distribution does not recognize
any gain or loss, and a partner who receives a current distribution cannot recognize a loss.
The partner will recognize gain, however, to the extent that the money he receives in the
distribution exceeds his basis in his partnership interest (also known as "outside basis")
immediately before the distribution. If a distribution includes both money and other
property, the partner’s gain resulting from the distribution of money is calculated before
the effects of the other property on the partner’s outside basis are taken into account. Any

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gain is treated as gain from the disposition of the partner’s partnership interest, and is
thus generally considered capital gain.

Ex: A is a 50% partner in partnership AB. A has a basis in his interest of $20,000. AB
makes a current distribution to A of cash of $18,000 and property with a FMV of
$6,000. Because the calculation of A’s gain, if any, is determined before any reduction to
A’s outside basis upon the receipt of the property with a FMV of $6,000, A recognizes no
gain on the distribution because the cash received ($18,000) does not exceed A’s basis in
his partnership interest ($20,000). If AB distributed cash of $21,000 to A in addition to
the property with a FMV of $6,000, A would recognize gain of $1,000 ($21,000 -
$20,000).

Partner’s Basis in Distributed Property: Section 732

Under the general rule of Section 732, a partner takes a basis in any property distributed
equal to the partnership's basis (or "inside basis") in the property.

Ex: Partner A, with an adjusted basis of $15,000 in his partnership interest, receives in a
current distribution property having an adjusted basis of $11,000 and a FMV of $17,000
to the partnership immediately before distribution, and $3,000 cash. The basis of the
property in A's hands will be $11,000, the same basis the partnership has in the
property.

Before the distribution, the appreciation inherent in the asset held by the partnership
was $6,000 ($17,000-$11,000). Rather than requiring the partnership to recognize
$6,000 of gain upon the distribution to A, however, as shown above, no gain is
recognized. Instead, the gain of $6,000 is preserved by giving A a basis in the property
of $11,000. Now, if A sells the property for its FMV of $17,000, A will recognize the
$6,000 of gain that the partnership did not recognize.

However, the partner’s basis in the distributed property cannot exceed the partner’s
outside basis reduced by the amount of any money distributed to the partner in the same
distribution.

Ex: Partner R has an adjusted basis of $20,000 in his partnership interest. He receives a
current distribution of $14,000 cash and property 1 with an adjusted basis to the
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partnership of $8,000 and a FMV of $12,000. The basis of the distributed property 1 to R
is limited to $6,000 ($20,000, the adjusted basis of his partnership interest, reduced by
$14,000, the cash distributed). No gain is recognized by R because the cash received
($14,000) does not exceed R's outside basis in his partnership interest.

In this example, at first blush it appears that more than the $4,000 of gain inherent in the
partnership's property 1 will be recognized when R sells the property. R has taken a basis
of $6,000, so that when he sells property 1 for its FMV of $12,000, he will recognize
$6,000 of gain. What gives?

Looking at things logically, assume that R received his $20,000 of outside basis by
contributing $20,000 of cash to the partnership for a 50% interest. Partner S also
contributed $20,000 for a 50% stake. The partnership then takes $8,000 of the $40,000
of cash and purchases property 1.

After property 1 appreciates to a value of $24,000, 1/2 of the property is distributed to R

in the example above, along with $14,000 in cash. After the distribution, all that will
remain within the partnership is $18,000 in cash ($32,000 - $14,000 distributed to R).
However, partner S, the other 50% partner, continues to have an outside basis in his
partnership interest of $20,000, because he is unaffected by the distribution to R. As a
result, if the partnership is liquidated and the remaining $18,000 of cash is distributed to
S, S will recognize $2,000 of loss under the rules discussed below for liquidating
distributions.

Remember, the partnership had one asset, property 1, with appreciation of $4,000. If S
would recognize a $2,000 loss on a liquidation of the partnership that follows the
distribution to R, then R should be required to recognize $6,000, rather than $4,000, of
gain on a subsequent sale of property 1, so that the total gain recognized by both parties
equals the appreciation inside the partnership of $4,000. The system works.

Allocation of Reduction in Basis Among Multiple Properties

When the pre-distribution bases of the distributed properties (other than money) exceed
the partner’s remaining outside basis after reduction for money received, the bases of the
properties must be reduced, and this reduction must be allocated among the distributed
properties.
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If the distribution does not include any inventory items or unrealized receivables (“hot
assets”), the basis reduction is first allocated among all of the distributed properties to the
extent of their unrealized depreciation. If the basis reduction exceeds the properties’
unrealized depreciation, the remaining basis reduction is allocated according to their
relative bases (taking into account the reduction allocated to unrealized depreciation).

Ex: A is a partner in partnership P. A has an outside basis of $150. A receives a current

distribution of $50 in cash as well as properties X and Y which are not hot assets. X has a
basis of $75 and a FMV of $65. Y has a basis and FMV of $65. The total basis of the
distributed properties is $140 ($75 + $65), A’s remaining outside basis after reduction
for money received is $100 ($150-$50). Thus, A must take a basis in the properties is
$100, and so A is required to reduce the basis of X and Y from $140 to $100. The first
$10 of the $40 basis reduction is allocated to X to the extent of its unrealized depreciation
of $10 ($75 - $65). This reduces A's basis in Y from $75 to $65. The remaining $30 of
basis reduction is allocated $15 each to X and Y because they have the same remaining
basis of $65. Thus, after the distribution, X and Y each have a $50 basis, giving A the
total basis of $100 required by Section 732.

If the distribution includes both hot assets and other property, and the partner’s outside
basis after reduction for money received exceeds the basis of the hot assets then (i) the
partner’s basis in hot assets equals their pre-distribution bases and (ii) the basis reduction
is allocated among the other property distributed as discussed above.

Ex: The facts are the same as previous example, except that in addition to X and Y, P
distributes $40 of cash and an inventory item that has a pre-distribution basis of $20. As
remaining basis after reduction for money received is $110 ($150-$40), so A must take a
basis in the distributed property of $110. The total pre-distribution basis of the
distributed property is $160 ($65+$75+$20), however, so the required basis reduction is
$50 ($160 -$110). Because A’s outside basis after reduction for money received is $110
exceeds the basis of the hot assets of $20, the first $20 of basis is allocated to the
inventory. A then starts by reducing the basis of Y by $10 to match its unrealized
depreciation. This reduces Y’s basis to $65 and reduces the required basis reduction to
$40. The remaining basis reduction is allocated $20 each to X and Y because they have the
same remaining basis of $65. After the distribution X and Y each has a $45 basis.

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If the distribution includes hot assets and the partner’s outside basis after reduction for
money is less than the basis of the hot assets, then all of the required basis reduction will
be allocated to the hot assets, and the other property distributed (if any) will take a basis
of zero.

Ex: A is a partner in partnership P. A has an outside basis of $60. A receives a current

distribution of $50 in cash as well as inventory of $30 and properties X and Y which are
not hot assets. X has a basis of $75 and a FMV of $65. Y has a basis and FMV of $65.
After reduction for the cash distributed, A has an outside basis of $10. Because the pre-
distribution basis of the hot assets of $30 exceeds the outside basis of $10, A takes a basis
in the hot assets of $10 and a basis in X and Y of $0.

Partner’s Outside Basis

As we've already learned above, a current distribution reduces a partner’s outside basis by
(i) the amount of money distributed to him and (ii) the basis that the partner takes in any
distributed property. A partner’s outside basis cannot be reduced below zero.

Ex: A is a partner in partnership ABC. A receives a current distribution of $10,000 of

cash and property X, which has an adjusted basis of $12,000 and a fair market value of
$20,000. Prior to the distribution, A’s basis in his partnership interest was $25,000.
After the distribution, A’s basis is $3,000 (his $25,000 starting basis, less $10,000 of
cash, less the $12,000 basis of property X as determined under IRC § 732). The fact that
property X had a FMV of $20,000 is inconsequential; instead, the $8,000 of gain
inherent in property X will be recognized if and when A sells the property.

Liquidating Distributions

Gain Recognition: Section 731

A liquidating distribution is a distribution that completely terminates a partner's interest

in the partnership. Just like with a current distribution, a partnership making a
liquidating distribution does not recognize any gain or loss. Also just like a current
distribution, a partner who receives a liquidating distribution will recognize gain to the
extent that the money he receives in the distribution exceeds his outside basis in the
partnership interest immediately before the distribution. If a partnership distributes both
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money and other property, the partner’s gain is calculated before the effects of the other
property on the partner’s outside basis are taken into account. Any gain recognized is
treated as gain from the disposition of the partner’s partnership interest, and thus is
considered capital gain.

Ex: A is a 33% partner in partnership ABC. A has a basis in his interest of $10,000. ABC
makes a liquidation distribution to A of cash of $8,000 and property with a FMV of
$3,000. Because the calculation of A’s gain, if any, is determined before any reduction to
A’s outside basis upon the receipt of the property with a FMV of $3,000, A recognizes no
gain on the distribution because the cash received ($8,000) does not exceed A’s basis in
his partnership interest ($10,000). If AB distributed cash of $11,000 to A in addition to
the property with a FMV of $3,000, A would recognize gain of $1,000 ($11,000 -
$10,000).

Partner’s Basis in Distributed Property: Section 732

The sum of the bases of the property a partner receives in a liquidating distribution must
equal the partner’s pre-distribution outside basis, reduced by any money distributed. In
effect, the basis of the distributed properties are "plugged" to equal the amount of
the partner's remaining outside basis. If the sum of the pre-distribution bases of the
distributed properties (other than money) is different than the outside basis reduced by
money distributed, the pre-distribution bases of the distributed properties are either
increased or reduced so that they equal the target basis.

If the pre-distribution bases of the distributed properties (other than money) is greater
than the partner’s outside basis after reduction for money received, their bases must be
reduced to match the target basis and this reduction must be allocated among the
distributed properties under the rules discussed above for current distributions.

Ex: A is a partner in partnership P. A’s outside basis in his partnership interest is $200.
P distributes properties X and Y to A in liquidation of his partnership interest. X has a
pre-distribution basis and FMV of $150. Y has a pre-distribution basis of $150 and a
FMV of $50.

The basis of the property distributed is $300 ($150+$150), but A’s outside basis after
reduction for money received is only $200. As a result, A must take a basis in the
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properties of $200, and thus the required basis reduction is $100. Y has $100 of
unrealized depreciation so the entire basis reduction is allocated to Y. A takes a basis of
$150 in X and $50 in Y.

If the pre-distribution bases of the distributed properties (other than money) are less than
the partner’s outside basis after reduction for money received, their bases must be
increased to match the target basis and this increase must be allocated among the
distributed properties. Hot assets such as inventory and cash-basis receivables cannot take
a basis that is larger than their pre-distribution basis. Thus, all of the basis increase is
allocated among the other property distributed.

The basis increase is first allocated among the other property up to the amount of their
unrealized appreciation. If the basis increase exceeds the other properties’ unrealized
appreciation, the remaining basis increase is allocated according to their relative FMVs.

Ex: A is a partner in partnership P. A’s outside basis in his partnership interest is $650. P
distributes inventory items and properties X and Y to A in liquidation of his partnership
interest. The inventory items have a pre-distribution basis of $100 and a FMV of $200. X
is a not a hot asset and has a pre-distribution basis of $50 and a FMV of $400. Y is a not
a hot asset and has a pre-distribution basis and FMV of $100.

The basis of the distributed assets are $250 ($100+$50+100), but A’s basis after
reduction for money received is $650. As a result, A must take a basis in the properties of
$650, and thus the required basis increase is $400. The inventory takes a basis of $100
to match its pre-distribution basis, because the basis of hot assets cannot be increased. X
has $350 of unrealized appreciation, so $350 of the $400 basis increase is allocated to X.
The last $50 of basis increase is allocated $40 to X and $10 to Y according to their
relative FMVs (X=$400, Y=$100). Thus, the basis of the inventory is $100, the basis of X
is $440, and the basis of Y is $110.

Loss Recognition and Partner’s Basis in Distributed Property

If a distribution consists only of money and/or hot assets and the sum of (i) the amount of
money distributed plus (ii) the partner’s basis in the distributed hot assets is less than the
partner’s outside basis, the distributee partner will recognize a loss. The partner’s
recognized loss will equal the excess of the partner’s outside basis over the sum of the
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amount of money distributed and the basis that the partner takes in the hot assets
distributed.

This result makes sense. If additional property were distributed, the loss could be
preserved by increasing the basis of the other property. When only money, inventory items
and unrealized receivables are distributed, however, the basis of those items are not
permitted to be increased to preserve this loss. As a result, the loss should be recognized
when the distribution is made.

Ex: Partner A has a partnership interest in partnership ABC with an adjusted basis to
him of $15,000. He retires from the partnership and receives, as a distribution in
liquidation of his entire interest, cash of $9,000 cash and inventory with a basis to him,
as determined by IRC § 732, of $3,000. A recognizes a capital loss of $3,000
($15,000-$9,000-$3,000).

Impact of Previous Section 743 Adjustments on Partner Basis in Distributed

Property

When a partner acquires an interest in a partnership from an existing partner, the

partnership may have to adjust the basis of its property. The partnership is required to
make Section 743 adjustments if it has a Section 754 election in effect or if it has a
substantial built-in loss immediately after the transfer. We discussed Section 754
adjustments in great detail here. The adjustment reflects the difference between the
acquiring partner’s outside basis and his proportionate share of the partnership’s inside
basis. An adjustment to the basis of a partnership property is specific to the partner who
acquires the partnership interest and applies only to that partner.

If property with a Section 743 adjustment is distributed to a partner, the Section 743
adjustment for the property is taken into account under Section 732 only if the Section 743
adjustment is specific to the distributee partner. In that case, for purposes of determining
the partner’s basis in the distributed property, its basis to the partnership before the
distribution includes the Section 743 adjustment.

Ex: A and B are partners in partnership P and each has a basis in their partnership
interest of $2,000. P holds property Z in which it has a $1,000 basis, property Y in which
it has a $2,000 basis and $2,000 in cash. A, who previously acquired his interest from
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partner X when the partnership had a Section 754 election in effect, has a $500 upward
Section 743 adjustment in Z. B has no Section 743 adjustment in Z. P distributes Z to A.
A’s $500 adjustment is considered part of the partnership’s basis in Z before the
distribution and A will take a $1,500 basis in Z ($1,000 + $500).

If a partner has a basis adjustment for a partnership property and that property is
distributed to another partner, the basis adjustment is not taken into account in
determining the distributee partner’s basis in the distributed property. Instead, the basis
adjustment is allocated among the partnership’s retained properties according to the rules
for allocating Section 734 adjustments.

Ex: The facts are the same as in the previous example, except that P distributes Z to B.
The Section 754 adjustment is not taken into account in determining B’s basis in Z, and B
takes a $1,000 basis in Z. A’s $500 Section 743 adjustment in Z is shifted to Y.

Section 734 Adjustments

Under Section 734, a partnership that has a Section 754 election may also be required to
make adjustments to its retained property when it makes a distribution to a partner if i)
the partner’s basis of the property after the distribution is not equal to the basis of the
property in the hands of the partnership, or ii) the partner recognizes a gain or loss on the
distribution.

Amount of Section 734(b) Basis Adjustment

If a partnership makes a distribution and a Section 734 adjustment is required, the

partnership must increase the inside basis of its retained property by the sum of (i) the
amount of gain recognized by the distributee partner on the distribution under Section
731(a)(1) and (ii) the amount the basis of distributed property is reduced as a result of the
distribution under Section 732(a)(2). This is done to prevent the same economic gain from
being taxed twice, once by the distributee partner, and again by the partnership.

Ex: A and B each contribute $600 to Partnership P. The partnership buys property X for
$200 and retains the $1,000 in cash. Later, when Partnership X had increased in value
from $200 to $1,000, and at a time when Partnership P has a Section 754 election in
effect, the partnership makes a current distribution to partner A. The distribution
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consists of $500 cash and 1/2 of property X with a basis to P of $100 and a FMV of $500.
Immediately before the distribution, A’s outside basis was $400.

A recognizes $100 of gain when he receives $500 of cash. Because his basis has been
reduced to zero, he takes a zero basis in the distributed property under Section 732. P has
to increase the basis of its retained property by $200.

Before the distribution, the total appreciation in asset X was $800. Upon the
distribution, A recognized $100 of gain, and took a reduced basis in 1/2 of X of $0, so
that when A sells property X, he will recognize $500 of gain rather than his original
share of $400. Without an adjustment to Partnership P's basis in the remaining 50% of
property X, upon a sale of 1/2 of X by P and 1/2 of X by A, $1,000 of total gain will be
recognized ($400 by P, $100 by A on the distribution, and $500 by A on the sale of 1/2 of
X). To remedy this, Section 754 requires P to increase the basis of its share of X from
$100 to $300. This way, when P sells the asset for its value of $500, only $200 of gain
will be recognized. This makes the total gain recognized $800 ($200 by P, $100 by A on
the distribution, and $500 by A on the sale of 1/2 of X), which equals the appreciation
inherent in X prior to the distribution ($1,000 - $200).

If a partnership makes a distribution and a Section 734 adjustment is required, the

partnership must also reduce the basis of its retained property by (i) the amount of loss
recognized by the liquidated partner on the distribution under Section 731(a)(2) and (ii)
the amount the basis of the distributed property is increased as a result of the distribution
under Section 732(b).

Ex: A is a partner in partnership P which has a Section 754 election in effect and no
outstanding liabilities. A has an outside basis of $11,000 in his interest in P. P distributes
$10,000 in cash to A in a liquidating distribution. A recognizes $1,000 of loss and P must
reduce the bases of its retained properties by $1,000.

Both the distributee partner’s recognition of loss and an increase in the basis of the
distributed property are only caused by liquidating distributions. Thus, Section 734
adjustments that reduce the basis of a partnership’s assets are triggered only by
liquidating distributions. Additionally, distributions that cause the distributee partner to
recognize loss and distributions that increase the basis of the distributed property are

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mutually exclusive, so it is not necessary to add these amounts together to determine the
amount of a Section 734 adjustment.

That's a lot to take in. Let's regroup next week and take a look at the "mixing bowl" rules.

Got an idea for a Tax Geek Tuesday? send it along to @nittigrittytax

Tony Ni i

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I am a Tax Partner with RubinBrown in Aspen, Colorado. I am a CPA licensed in Colorado and New
Jersey, and hold a Masters in Taxation from the University of Denver. My ... Read More