Unlike the rules that apply to C corporations, which tax income both at the entity and at the owner level, the partnership rules are designed to only tax income once, at the owner level. A partnership’s income, losses, deductions, and credit are passed through to the partners for Federal tax purposes and taxed directly to them, regardless of when income is distributed.[1]
Since the partners have already paid tax on the income when it is earned, a complex system of rules applies to prevent double taxation when the income is later distributed to the partners. These rules (a) allocate the partnership’s income, losses, deductions, and credit among the partners and (b) adjust basis to reflect each partner’s allocation of those items.
As stated in Taxation of Limited Liability Companies and Partnerships, limited liability companies are taxed as partnerships by default. This discussion of the tax consequences of contributions to partnerships will also apply to limited liability companies unless the limited liability company has elected to be taxed as a corporation.
Tax Consequences to the Partner or Limited Liability Company Member
As with S corporations, the tax consequences of a distribution to a partner are heavily dependent on the partner’s basis in his partnership interest. A partner’s initial basis in his partnership interest depends on how the partner acquired the interest. If the partner acquired the interest in exchange for a contribution to the partnership, his basis generally equals the amount of money and the partner’s adjusted basis in any property contributed to the partnership.[2] If the property is subject to indebtedness at the time of the contribution, the partner’s basis is reduced by the portion of the debt that is assumed by the other partners.[3] If the partner acquired his interest in exchange for services, his basis equals the value of services provided.[4] If the partner purchased his partnership interest, his basis equals his cost.[5]
The partner’s initial basis is adjusted to give effect to transactions affecting the partnership. The partner’s basis in his partnership interest in increased by:
- Any further contributions the partner makes to the partnership;[6]
- Any amount paid for additional interests in the partnership;[7]
- An increase in the partner’s share of partnership liabilities (which are treated as a deemed contribution to the partnership by the partner);[8]
- The taxable and tax-exempt income of the partnership that is allocated to the partner, including the excess of percentage depletion deductions over the basis of the property subject to depletion.[9]
The partner’s initial basis in the partnership interest is decreased (but not below zero) by:
- The partner’s adjusted basis in any partnership interest that is sold or transferred;
- Any decrease in his share of partnership liabilities (which are treated as a deemed distribution by the partnership to the partner);[10]
- Distributions from the partnership;[11]
- The partner’s distributive share of losses of the partnership and nondeductible expenditures of the partnership that that are not properly chargeable to a capital account;[12] and
- The amount of the partner’s depletion deduction for any partnership oil and gas property (but only to the extent that the deduction doesn’t exceed the proportionate share of the basis in the property allocated to the partner.[13]
These basis adjustments depend in large part on the allocation of partnership income, gains, losses, deductions, and credit among the partners. The partnership agreement determines the allocation of these items.[14] If the partnership agreement is silent, these items are allocated in accordance with the partnership interests.[15] If the partnership agreement allocates partnership items among the partners, the allocation is respected as long as one of the following is true:
- The allocations have substantial economic effect.[16] Substantial economic effect requires that the partner’s capital accounts are determined and maintained in accordance with the Treasury Regulations; that liquidating distributions are made in accordance with capital account balances; and that a partner with a deficit in his account balance must restore the amount of the obligation to the partnership.[17] The allocation must also affect the dollar amounts received by the partners from the partnership (apart from tax consequences).[18]
- The allocations are in accordance with the partnership interests.
- The allocations are deemed to be in accordance with the partnership interests pursuant to one of the special rules contained in the Treasury Regulations.[19]
If an allocation does not meet one of these requirements, the allocation of income, gain, loss, deduction, or credit is reallocated in accordance with the partner’s interest in the partnership.[20] Special rules apply to allocations of property with built-in gain and loss.[21]
These adjustments to basis work with the rules governing distributions to ensure that partnership income is taxed and deductions are taken only once. A partner will not recognize gain or loss on a distribution, with three exceptions:
- A partner will recognize gain if money or marketable securities are distributed to him and the value exceeds the partner’s adjusted basis in his partnership interest as determined immediately before the distribution.[22]
- In some circumstances, a partner will recognize loss on a distribution in liquidation of the partner’s interest if no property other than money and unrealized receivables is distributed the partner.[23]
- A partner may recognize gain or loss on a distribution of property that was contributed to the partnership by the partner within 7 years of the distribution.[24]
If the partner receives an in kind distribution from the partnership (other than a liquidating distribution), the partner’s basis in the property received equals the property’s adjusted basis in the hands of the partnership immediately before the distribution (but not in excess of the partner’s basis in his partnership interest), less any money distributed in the same transaction.[25] A partner’s basis in property distributed in kind as part of a liquidating distribution is the same as his basis in the partnership, reduced by money distributed to him in the same transaction.[26]
Tax Consequences to the Limited Liability Company or Partnership
No gain or loss is recognized to a partnership on a distribution of property or money to a partner.[27] The one exception is for disproportionate distributions, which are treated as a sale or exchange by the partnership.
For S corporations, this deemed sale results in gain recognized by the S corporation, which is passed through to the shareholders and increases their basis in the S corporation stock.[29] The distribution then reduces the shareholder’s basis.[30] Assuming the S corporation has no accumulated earnings and profits, the shareholder will have no gain on the later distribution except to the extent that the amount of the distribution exceeds his adjusted basis in the stock.[31]
Tax Consequences of Sale or Liquidation
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.[32] 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).[33]
The buyer of the partnership interest will have a cost basis.[34] By default, the buyer-partner will inherit the selling-partner’s capital account.[35] Because partnership assets may have appreciated or depreciated in value, this usually results in a disparity between the buyer-partner’s basis in his partnership interest (outside basis) and his allocation of the partnership’s basis in each of the assets owned by the partnership (inside basis). To resolve this disparity, Code § 754 allows the partnership to make special basis adjustments to the inside basis of the partnership assets.
The liquidation of a partner’s interest may represent his interest in the fair market value of the partnership’s assets, his interest in unrealized receivables, or guaranteed payments for his interest.
- To the extent that the payment represents the partner’s interest in the fair market value of the partnership’s assets, it is treated as a distribution to the partner under the normal distribution rules.[36]
- To the extent that the payment represents the partner’s interest in unrealized receivables, the partner will have ordinary income or loss.[37]
- To the extent that the payment is a guaranteed payment, it is governed by the rules applicable to guaranteed payments under Code § 707(c).[38]
A partnership is ordinarily treated as terminating for tax purposes (regardless of whether it actually terminates) if it stops doing business as a partnership or if 50 percent or more of the total interest in partnership capital and profits changes hands by sale or exchange within 12 consecutive months.[39] Contributions of property in exchange for partnerships and gifts, bequests, inheritances, and liquidations are not counted for purposes of this 50 percent test, even if the result is more than a 50 percent change.[40]