A distribution is a transfer of cash or property by a partnership to a partner with respect to the partner's interest in partnership capital or income. Distributions do not include loans to partners or amounts paid to partners for services or the use of property, such as rent, or guaranteed payments.
A partnership distribution may consist of cash, property, or both. In addition, any reduction of a partner's share of partnership liabilities is treated as an actual distribution of cash (Sec. 752(b)). Transactions that should be carefully reviewed for such potential gain include distributions of encumbered property, distributions in partial liquidation of a partner's interest, and the admission of a new partner.
A like-kind exchange involving encumbered property can also result in a deemed distribution under Sec. 752 to the extent the mortgage assumed in the exchange is less than the mortgage transferred. Regs. Sec. 1.1031(b)-1(c) provides that a net reduction in debt due to the exchange of encumbered property is considered boot, and gain is recognized. Under Rev. Rul. 2003-56, if such a like-kind exchange straddles two tax years, the gain that is recognized due to the receipt of boot that resulted from a net decrease in liabilities is reported in the tax year in which the partnership transfers the relinquished property and not the year in which the partnership receives the replacement property.Distinguishing Loans From Distributions
In some situations, it may be difficult to distinguish between distributions and partnership loans to partners. Moreover, partners may sometimes attempt to avoid immediate taxation on a distribution by characterizing it as a loan. The substance of the transaction determines whether the transfer of funds is a loan or a distribution. An advance of funds to a partner is characterized as a loan only if there is an unconditional and legally enforceable obligation to repay a sum certain—the amount of the advance—at a determinable date (Regs. Sec. 1.731-1(c)(2)). A mere deficit balance in a partner's capital account does not constitute a loan for this purpose, even if the partner is obligated by law or by the partnership agreement to repay the deficit to the partnership (Rev. Rul. 73-301; Mangham, T.C. Memo. 1980-280; Seay, T.C. Memo. 1992-254). When a loan from a partnership to a partner is intended, there should be a written loan document with commercially reasonable terms that provides a market interest rate.
If a true loan is made, a later cancellation of the debt constitutes a distribution of money at the time of cancellation (Rev. Rul. 57-318, clarified by Rev. Rul. 73-301). On the other hand, if the IRS successfully argues there never was a loan, the purported loan is treated as a partnership distribution at the time it was made.Preferred Returns
Frequently, partnership agreements call for preferred distributions to partners. These are normally included in the partnership agreement to provide a preferred return on the capital invested by a partner. The provisions regarding preferred returns can take many forms that may lead to different tax treatment.
Preferred returns are usually equal to a stated rate times a partner's unreturned capital. Depending on the partnership agreement, a partner's unreturned capital may be defined as the partner's capital contribution less non-pro-rata distributions to that partner, as the partner's capital contribution less distributions other than the preferred return, as the partner's capital contribution less all distributions, or in some other manner. The return may be mandatory or discretionary and may be cumulative or noncumulative.
- If the preferred distribution is guaranteed, but the return of the capital on which the preference is calculated is not guaranteed, the preferred distribution will most likely be classified as a guaranteed payment. Such payments are income to the partner who receives the payment, are deductible by the partnership, and do not affect the partner's capital account.
- If the preferred distribution is guaranteed and the return of the capital on which the preference is calculated is also guaranteed, the preferred distribution may be recharacterized as interest on a loan.
- If the preferred distribution is in connection with a contribution of property to the partnership, it may be part of a disguised sale.
- If the preferred distribution is not guaranteed, it will be treated as a current partnership distribution. The allocation provisions of the partnership agreement may or may not require that the payment of the distribution carry with it an allocation of income.
Planning tip: Practitioners should make sure that partners are very clear on how any preferred distribution requirements will interact with the allocation provisions of the partnership agreement to impact the distribution of sale or liquidation proceeds.
This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 29th Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Cynthia Zatopek, Sheila A. Owen, and M. Andrew Vance, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
|Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.|