Question

When a partner receives a current (nonliquidating) distribution, the distribution is generally nontaxable. Why is this the case? When would a current distribution be taxable?

Answer 1

A partner may withdraw from a partnership by either sale or liquidation of his partnership interest. A partner’s sale of his partnership interest is taxable. The seller-partner will recognize ordinary income to the extent that the gain from the sale of his partnership interest is attributable to unrealized receivables and inventory. The seller-partner’s capital gain or loss equals the difference between the amount the partner realizes in the sale (reduced by the portion attributable to unrealized receivables and inventory) and the seller-partner’s adjusted basis in his partnership interest (also reduced by the portion attributable to unrealized receivables and inventory).

Distribution of partnership assets can be done as either current distribution or liquidating distribution. A current distribution is when a partnership makes a distribution to the partner(s). The receiving partner’s capital interest is retained fully or partially (IRC Sec. 761(d)). Even if the distribution reduces partner’s interest in the partnership from 80% to 2%, this distribution will be considered current.

If partnership makes a distribution in excess of partner’s basis in the partnership, a taxable event may take place.

Example: Simon and Jaby are 50/50 partners in a Simon and Jaby’s Plumbing. Simon contributed $10,000 cash and Jaby contributed $5,000 cash to the partnership. At the end of the first tax year, the "Simon and Jaby's Plumbing" partnership has generated $4,000 in profits. "Simon and Jaby's Plumbing " distributes $8,000 cash to each partner.

Simon's Distribution is not taxable	Jaby's Distribution is Taxable
$10,000 Initial capital contribution add $2,000 (50% Partnership profit) $12,000 basis (capital) Less $8,000 cash distribution Simon’s basis in partnership interest after the distribution is $4,000.	$5,000 initial capital contribution add $2,000 (50% Partnership profit) $7,000 basis (capital) Less $8,000 cash distribution Jaby’s basis in partnership interest after the distribution is -$1,000. However, basis cannot be below “0”, therefore $1,000 is the excess (7K basis-8K distribution) which is taxable to Jaby.

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