Partnership distributions: Rules and exceptions

Entities classified as partnerships for federal tax purposes often provide the preferred tax structure for a business owner because of their flowthrough nature and the flexibility they offer regarding their formation, allocations of profits and losses, and distributions. Each of these characteristics can provide benefits that may not be obtainable as easily, if at all, in a corporate tax structure. This article explores partnership distributions, including the general rules, complexities that can arise, exceptions to the general rules, and exceptions to the exceptions.  Understanding these concepts can help partnerships and partners avoid missteps when making distributions or determining what their appropriate tax impact is.

Background and key concepts

The basic rule for when a partner recognizes gain as a result of a distribution is found in Sec.  731(a)(1), which applies to both current distributions (from current income and activities) and liquidating distributions.  This section states that “gain shall not be recognized to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner’s interest in the partnership immediately before the distribution.” Several important aspects of this provision must be understood and analyzed to determine whether gain needs to be recognized.

First, a partner needs to know their adjusted basis.  While various Code sections can be implicated to accurately calculate the partner’s adjusted basis in their partnership interest, the basic rule is provided in Sec.  705(a).  The general formula is: 

Adjusted basis = [contributions (including increases to the partner’s share of liabilities) + taxable income + tax-exempt income] – [distributions (including decreases to the partner’s share of partnership liabilities) + taxable losses + nondeductible expenses].

Second, in determining whether a partner recognizes gain, distributions of other property are treated differently from money.  Sec.  731 states that gain may be recognized as a result of a distribution of money; however, in general, “[n]o gain shall be recognized to a distributee partner with respect to a distribution of property (other than money) until he sells or otherwise disposes of such property.”¹

Sec.  732 has a separate and partnerfriendly rule regarding the basis of distributed property.  For current distributions of property, a partner’s basis will generally be equal to the partnership’s basis in the property distributed (subject to certain limitations; see Example 2 below).  For liquidating distributions, the partner’s basis in the property will generally be equal to the basis of their partnership interest.

This is an important distinction between partnerships and C corporations. In the C corporation context, Secs.  301 (Distributions of Property) and 331 (Gain or Loss to Shareholder in Corporate Liquidations) look to the fair market value (FMV) of property received to determine the amount distributed and amount realized, respectively.  Sec.  732 has an important exception, which will be discussed in more detail related to distributions to partners of unrealized receivables and inventory items.

Three brief examples follow.  The first is a slight variation of the second two, which are drawn partly from Regs.  Sec. 1. 731-1(a)(1)(i). Assume in each of these examples that the distribution is a current distribution.

Example 1: A partner with an adjusted basis in their partnership interest of $10,000 receives a distribution of money of $8,000.  The partner would recognize no gain under Sec.  731 since the money distribution did not exceed the partner’s adjusted basis.  The partner’s adjusted basis would be reduced by $8,000 under Sec.  733(1).

Example 2: A partner with an adjusted basis in their partnership interest of $10,000 receives a distribution of cash of $8,000 and property with an FMV of $3,000.  No gain is recognized under Sec.  731.  The partner’s basis in the property under Sec.  732 would be $2,000, the lesser of the partnership’s adjusted basis in the property or the partner’s adjusted basis in their partnership interest, and the adjusted basis in their partnership interest would be $0 after application of Sec.  733.

Example 3: Assume the same facts as Example 1, except that the partner receives a distribution of money of $11,000.  The partner would recognize gain of $1,000, which is the amount by which the money distributed exceeds the partner’s adjusted basis in their partnership interest.  The partner’s adjusted basis would be reduced to $0, but not below $0, under Sec.  733(1).

Third, because different rules apply to distributions of money and other property, the definition of “money” is important. While most would equate the amount of money with the amount of cash received, the term “money” has a broader meaning in this context.  In fact, and often to the partner’s dismay, Sec.  731(a)(1) could be activated without the partner actually receiving cash during the year.  This is due to the treatment of a partner’s share of partnership liabilities under Sec.  752.  An increase in a partner’s share of partnership liabilities is considered a contribution of money by the partner.² Alternatively, a decrease in a partner’s share of partnership liabilities is considered a distribution of money to the partner.³

So, while a partner may benefit from inclusion of the liabilities in the adjusted basis of their partnership interest at a given point in time, that could flip at a future date due to a change in the liability allocation among partners or the debt being paid down or paid off by the partnership. Additionally, the term “money” includes marketable securities.⁴ While an in-depth discussion of this provision is beyond the scope of this article, it is important to note that Sec.  731(c) goes on to provide the definition of a “marketable security” for purposes of Sec.  731 and exceptions to the treatment of marketable securities as money.

Lastly, in determining whether a partner needs to recognize gain from a distribution, one must look at the adjusted basis of the partner’s interest in the partnership “immediately before the distribution.”⁵ This rule may lead one to believe that every time a partnership makes a distribution this basis analysis would be required.  Fortunately, Regs.  Sec.  1.731-1(a) (1) (ii) provides that “advances or drawings of money or property against a partner’s distributive share of income shall be treated as current distributions made on the last day of the partnership taxable year.” This provision may minimize the number of times the determination of adjusted basis needs to be made throughout the year.

It is important to note, however, that this provision states only that advances or drawings — not all current distributions — are treated as made on the last day of the partnership tax year.  Moreover, the terms “advance” and “drawing” are not defined. Despite some rulings on the correct timing of distributions,⁶ uncertainty may still exist in some situations about whether a distribution is treated as made on the last day of the partnership tax year.

Now that the “simple” matters are out of the way, this article next looks at some distributions that fall outside the purview of the general rules.  These will focus on situations where Secs.  731 and 732 would not apply, at least initially, and differences in income characterization and/or income recognition timing could arise.

Guaranteed payments

One area in which the general rules discussed above do not apply involves guaranteed payments.  These are payments determined without regard to income of the partnership that are made to a partner for services or the use of capital.⁷ In its simple form, a guaranteed payment can be illustrated by Example 1 of Regs.  Sec.  1.707-1(c):

Under the ABC partnership agreement, partner A is entitled to a fixed annual payment of $10,000 for services, without regard to the income of the partnership.  His distributive share is 10%.  After deducting the guaranteed payment, the partnership has $50,000 ordinary income.  A must include $15,000 as ordinary income for his tax year within or with which the partnership tax year ends ($10,000 guaranteed payment plus $5,000 distributive share).

However, as economic arrangements of partners become more sophisticated and complex, the determination of whether amounts paid to partners are considered a distributive share of income, guaranteed payment, or draws against future income can become more complicated. The difference between guaranteed payment and current distribution treatment was summarized in Klebanoff ⁸ as:

The major differences between the two positions concern the type and amount of tax that would result. Generally, payments received by a partner from a partnership that are determined without regard to the income of the partnership are classified as guaranteed payments under section 707(c) and are taxable as ordinary income under section 61(a).  Payments received by a partner that are determined with regard to partnership income and/or are in the nature of current or liquidating distributions may be taxable as capital gain to the extent that they exceed a partnerfs basis in the partnership. See sec.  731(a).  Additionally, advances against distributive shares are treated as current distributions at the end of the year pursuant to section 1.731-1(a) (1) (ii), Income Tax Regs.  Other differences are that payments made to a partner for services which are determined without regard to partnership income may be deductible by the partnership provided they otherwise satisfy the tests of section 162 and that such payments may be subject to Social Security or self-employment tax.

In Klebanoff, the taxpayer and three other individuals formed a partnership to develop, run, and sell “hospice in-patient units.” Each held a 25% interest in the partnership, but only two of the owners, of which the taxpayer was not one, contributed capital to it.  During 2007, the taxpayer received distributions of $51,000, which the draft operating agreement specified as “an advance on distributions” against their share of future profits. However, the taxpayer’s 2007 Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., received from the partnership reported the $51,000 as a guaranteed payment. The facts go on to indicate that at some point during 2007 “things began to unravel,” and by the end of 2007, operations ceased.

The court held that the $51,000 in this case was a distribution subject to Sec. 731(a) and not a guaranteed payment under Sec.  707(c).  Thus, the income was taxable as capital gain to the petitioner and not subject to self-employment tax. The court appeared to rely heavily on the language in the partnership agreement, which referred to the cash payments as advances on distributions against future profits.

Klebanoff highlights the potential differences that can arise in character of income and amount and type of taxes owed, depending on whether a payment is a guaranteed payment or distribution, as well as the importance of the partnership agreement addressing items such as this.  The correct tax year for inclusion of the income could also vary depending on whether such a payment is properly classified as a guaranteed payment or distribution.  This issue was not addressed in Klebanoff, as the income, regardless of character, was going to be recognized on the taxpayer’s 2007 return.  However, in other situations the distinction could make a difference.  Under Sec.  731(a), the partner would report income in the tax year in which the distribution of money exceeds the partnerfs adjusted tax basis in their partnership interest.  On the other hand, Regs.  Sec.  1.706-1(a)(1), addressing guaranteed payments, requires a partner to “include in taxable income for a taxable year guaranteed payments under section 707(c) that are deductible by the partnership under its method of accounting in the partnership taxable year ending within or with the partner’s taxable year.” As a result, a cash-basis partner could have to recognize income before actually receiving the cash if the partnership records the guaranteed payment on an accrual basis under its method of accounting.

Distributions involving the ‘mixing-bowl rules’

Another exception from the general rules on partnership distributions involves certain rules designed to prevent partners from avoiding tax when swapping property between themselves.  As mentioned earlier, partners generally recognize no gain from distributions of property other than money until they sell or otherwise dispose of the property. But under Secs.  704(c)(1)(B) and 737, known as the mixing-bowl rules, property distributions could trigger income to a partner.  These provisions will apply to certain distributions if a partner has previously contributed Sec.  704(c) property to the partnership.  As the regulations explain, “[p]roperty contributed to a partnership is section 704(c) property if at the time of contribution its book value differs from the contributing partner.s adjusted tax basis.”⁹

If Sec.  704(c) property is distributed “by the partnership (other than to the contributing partner) within 7 years of being contributed,” the contributing partner will recognize gain or loss equal to the amount of gain or loss the contributing partner would be allocated under Sec.  704(c)(1)(A) had the partnership sold the Sec.  704(c) property at its FMV on the date of the distribution.¹⁰ The Sec.  704(c)(1)(A) amount allocable to the contributing partner is equal to the property’s remaining built-in gain or loss.¹¹

Unlike in most other partnership distribution scenarios, where it is the partner receiving the distribution that may have to recognize gain, Sec.  704(c)(1)(B) requires the partner that contributed the Sec.  704(c) property, not the partner receiving the distribution, to recognize income.  An abbreviated and adapted version of the first of three examples in Regs.  Sec. 1.704-4(a)(5) illustrates this point.

Example 4: In 2021, A acquires an interest in Partnership ABC by contributing Property A, nondepreciable real property, to the partnership. Property A is Sec.  704(c) property due to its FMV of $10,000 differing from its adjusted basis of $4,000.  In 2024, Partnership ABC distributes Property A to Partner C in liquidation of C’s interest in the partnership.  Partner A would recognize gain under Sec.  704(c)(1)(B) since Property A was distributed to C within seven years.  The amount of gain that would be allocated to Partner A, as determined under Sec.  704(c)(1)(A), would be $6,000.

As many of the exceptions to Sec. 704(c)(1)(B) are equally applicable to Sec.  737, the discussion touches on them below.  However, there is a special rule under Sec.  704(c)(2) for distributions of like-kind property.  Regs.  Sec. 1. 704-4(d)(3) elaborates:

If section 704(c) property is distributed to a partner other than the contributing partner and like-kind property (within the meaning of section 1031) is distributed to the contributing partner [within a prescribed period], the amount of gain or loss, if any, that the contributing partner would otherwise have recognized under section 704(c) (1) (B) and this section is reduced by the amount of built-in gain or loss in the distributed like-kind property in the hands of the contributing partner immediately after the distribution.

The regulation goes on to provide an example that illustrates how the Sec. 704(c)(1)(B) gain could be reduced or even eliminated by the application of this rule.  With the right set of facts and proper planning, this rule could transform a taxable event into a nontaxable one.

A corollary provision, Sec.  737, addresses situations where a partner that previously contributed Sec.  704(c) property to a partnership receives a distribution of property other than money.  In this situation, Secs.  737(a)(1) and (2) would require the partner to recognize gain equal to the lesser of:

1. The excess distribution.  “The excess distribution is the amount (if any) by which the fair market value of the distributed property (other than money) exceeds the distributee partner’s adjusted tax basis in the partner’s partnership interest.”¹² The partner’s adjusted basis is reduced, but not below zero, for distributions of money received in the distribution; or
2. The partner’s net precontribution gain. The net precontribution gain is the same amount of gain that a partner would recognize under Sec.  704(c)(1) (B) if all property held by the partnership immediately before the distribution that was “contributed to the partnership by the distributee partner within 7 years of the distribution” was distributed to another partner.¹³

Example 5: Assume the same facts as Example 4, except that in addition to A’s contribution, Partner B contributes Property B, also nondepreciable real property, that has an FMV and adjusted basis equal to $30,000 (i.e., not Sec.  704(c) property).  In 2023, Partnership ABC distributes Property B to A in liquidation of A’s interest.  At the time of the distribution, Property B’s FMV is still $30,000, and A’s adjusted basis in their partnership interest is $20,000.  A would be required to recognize a gain of $6,000, which is A’s net precontribution gain, since that amount is less than the excess distribution amount of $10,000 (i.e., $30,000 minus $20,000).

Sec.  704(c)(1)(B) and Sec.  737 both have various and similar exceptions. First, no triggering event occurs when Sec.  704(c) property is distributed to the partner that contributed such property.  Second, distributions more than seven years after such property was contributed are not subject to the gain recognition rules of these sections. Regs.  Secs.  1.704-4(c) and 1.737-2 add to the list of exceptions certain liquidations, complete transfer to another partnership, incorporation of a partnership, and a few others, some of which are not identical.

Basis adjustments may be required for the partners and partnership as a result of the gain triggered by these sections, as discussed in Regs.  Secs. 1. 704-4(e) and 1.737-3. This may be of little comfort in the short term for the partner forced to recognize gain because of the distribution.

Distributions treated as disguised sales

Another exception to the general rules on partnership distributions involves contributions/distributions that are treated as disguised sales between a partner and the partnership.  The preamble to T.D. 8439 highlights that Sec 707(a)(2) “grants the Secretary broad regulatory authority to identify those transactions that, though structured as contributions and distributions under sections 721 and 731, are more properly treated under section 707(a) as sales or exchanges.” More specifically, Regs. Sec.  1.707-3, Disguised Sales of Property to Partnership, provides that “a transfer of property by a partner to a partnership and one or more transfers of money or other consideration by the partnership to that partner” will be treated as a sale of property if, based on all the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of property.¹⁴ Regs. Sec.  1.707-6, Disguised Sales of Property by Partnership to Partner, will treat a “transfer of property by a partnership to a partner and one or more transfers of money or other consideration by that partner to the partnership” as a sale under rules similar to those of Regs.  Sec.  1.707-3.

For determining whether a contribution/ distribution should be considered a disguised sale, the regulations provide a nonexclusive list of facts and circumstances that will be considered, with the weight given to each depending upon the situation.¹⁵ The factors that may tend to prove the existence of a sale include:

• The timing and amount of the subsequent transfer are determinable with reasonable certainty;
• The transferor has a legally enforceable right to the subsequent transfer;
• The right to receive the transfer of money or other consideration is secured; and
• The transfer of money or other consideration is disproportionately large in relation to the partner’s continuing interest in partnership profits.¹⁶

Transfers of property that occur within two years of a transfer of money “are presumed to be a sale  unless the facts and circumstances clearly establish that the transfers do not constitute a sale.”¹⁷. Transfers subject to this presumption require disclosure if the transfer is not treated as a sale.  On the other hand, the following are presumed not to be, or be part of, a sale of property unless the facts and circumstances clearly establish otherwise: 

• Transfers occurring more than two years apart;¹⁸
• Reasonable guaranteed payments;¹⁹
• Reasonable preferred returns;²⁰
• Distributions of operating cash flow;²¹ and
• Reimbursements of preformation expenditures.²²

Example 6: D contributes $100X to Partnership ABC in exchange for an interest in the partnership.  Partnership ABC owns three parcels of land, each with an FMV of $100X and a basis of $10X.  Partnership ABC distributes one of the parcels to D in liquidation of D‘s interest in the partnership.

If the transfers occurred within two years, it would be presumed that Partnership ABC sold the land to D for $100X unless the facts and circumstances established otherwise.  D will have a basis in the land of $100X whether the transaction is treated as a distribution or purchase.  If the distribution to D was respected, Partnership ABC would recognize no gain under Sec.  731(b), and any optional or mandatory basis adjustments required by Sec. 734 may allow for a deferral of the gain. However, disguised-sale treatment would require Partnership ABC to recognize gain of $90X.

There is a third set of transactions, disguised sale of partnership interests, where similar rules could apply.  However, Regs. Sec.  1.707-7, Disguised Sales of Partnership Interests, remains reserved currently, as previously issued proposed regulations have been withdrawn.  While some case law and plenty of commentary exists on this topic, there is less certainty and unanimity in this area due to the absence of regulations.

Distributions of unrealized receivables or substantially appreciated inventory

One other exception to the general rules on partnership distributions should be mentioned.  Under Sec.  751(b), certain distributions involving unrealized receivables or substantially appreciated inventory (referred to as Sec.  751 property) “are treated in part as sales or exchanges of property between the partnership and the distributee partner, and not as distributions to which sections 731 through 736 apply.”²³ The objective of these rules is to prevent the shifting of ordinary income between partners, and they do so by recharacterizing a portion of the distribution as a sale or exchange.  Sec.  751(b) applies only to the extent that a partner either receives Sec.  751 property in exchange for relinquishing any part of their interest in other property or receives other property in exchange for relinquishing any part of their interest in the Sec.  751 property.²⁴ The current regulations applicable to Sec.  751(b) use a seven-step approach and contain numerous defined terms. However, the basic principle of this section can be illustrated with this example: 

Example 7: Partnership ABC is owned equally by A, B, and C, who each have an adjusted basis in their partnership interest of $100X.  Partnership ABC‘s balance sheet reflects cash of $300X, an accounts receivable of $300X with a $0 tax basis, and no liabilities.  C receives a cash distribution of $200X in liquidation of *C’*s interest in the partnership.

*C‘*s $100X gain under Sec.  731(a), which would normally be capital gain, will be recharacterized as ordinary to the extent that C‘s interest in the accounts receivable decreases.  In this scenario, the entire $100X gain would be ordinary, since C‘s interest in the accounts receivable was reduced from $100X (onethird of $300X) to $0 as a result of the liquidating distribution.  This outcome replicates what would have happened if Partnership ABC had collected the receivable, recognized the income, and allocated $100X to each of its partners.  In that case, C‘s basis would have increased from $100X to $200X, and no gain would have been recognized under Sec. 731(a), since the cash distribution equaled C‘s adjusted basis in the partnership.

If the partnership had distributed $200X of the accounts receivable to C in liquidation of C‘s interest, the partnership, not C, would recognize a gain under Sec.  751(b), and it would be allocated to A and B.

Like many of the prior topics discussed above, Sec.  751(b) has an exception for distributions “of property which the distributee contributed to the partnership.”²⁵. Sec.  751(b) also does not apply to the extent that a distribution consists of the distributee partner’s share of Sec.  751 property or their share of other property.²⁶ In the above example, if Partnership ABC had distributed $100X of cash and $100X of accounts receivable to C in liquidation of C’s interest, Sec. 751(b) would not apply, since there would be no relinquishment of Sec.  751(b) property in exchange for other property or vice versa.

Taxpayers should also be aware that proposed regulations were issued in 2014 and can be relied on currently as long as they are applied consistently to all partnership sales, exchanges, and distributions.²⁷ The proposed regulations more adequately address the complex allocations of profits, losses, and capital of today’s partnerships and may provide opportunities not available under the current regulations. Other considerations remain A number of other Code sections besides those listed above may be implicated when a distribution is made by a partnership to a partner.  These could include Sec. 736, addressing payments to a retiring partner, as well as provisions outside Subchapter K, such as Sec.  465, covering the at-risk loss limitations, or Sec.  1061, dealing with applicable partnership interests.

Understanding the partnership distribution concepts discussed above, including the exceptions to the general rules and the exceptions to the exceptions, can help prevent oversights when making distributions to partners or determining the tax impact they will have.

Footnotes

¹ Regs. Sec. 1.731-1(a)(1)(i).

² Sec. 752(a).

³ Sec. 752(b). 

4 Sec. 731(c)(1)(A).

⁵ Sec. 731(a)(1).

⁶ See Rev. Ruls. 92-97 and 94-4. See also Regs. Sec. 1.761-1(d).

⁷ Sec. 707(c).

⁸ Klebanoff, T.C. Summ. 2011-46.

⁹ Regs. Sec. 1.704-3(a)(3)(i).

¹⁰ Sec. 704(c)(1)(B).

¹¹ Regs. Sec. 1.704-3(a)(3)(ii).

¹²Regs. Sec. 1.737-1(b).

¹³Sec. 737(b) and Regs. Sec. 1.737-1(c).

¹⁴Regs. Secs. 1.707-3(a)(1) and (b)(1).

¹⁵Regs. Sec. 1.707-3(b)(2).

¹⁶Regs. Secs. 1.707-3(b)(2)(i), (ii), (iii), and (ix).

¹⁷Regs. Sec. 1.707-3(c)(1).

¹⁸Regs. Sec. 1.707-3(d).

¹⁹Regs. Sec. 1.707-4(a)(1)(ii).

²⁰Regs. Sec. 1.707-4(a)(2).

²¹Regs. Sec. 1.707-4(b).

²²Regs. Sec. 1.707-4(d).

²³Regs. Sec. 1.751-1(b)(1)(i).

²⁴Id.

²⁵Sec. 751(b)(2)(A).

²⁶Regs. Sec. 1.751-1(b)(1)(ii).

²⁷REG-151416-06, 79 Fed. Reg. 65, 151 (Nov. 3, 2014).

Contributor

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio. For more information about this article, contact thetaxadviser@aicpa.org.