Tax consequences of liquidating

Whether earnings are retained in a partnership or distributed to partners has no affect on the taxation of those earnings, since the partners have to pay tax on the earnings whether they are distributed or not.Earnings are distributed to each partner's capital account from which distributions are charged against.However, certain types of distributions and any distributions that exceed the partner's basis may result in gains or losses that must be reported for the year in which they occur.

The inside basis is the partnership's tax basis in the individual assets.

The outside basis is the tax basis of each individual partner's interest in the partnership.

When a partner contributes property to the partnership, the partnership's basis in the contributed property is equal to its fair market value (You contribute land to a partnership with a tax basis of $10,000 and a FMV of $50,000. Since the FMV of the land is also $50,000, you each have equal equity in the partnership, and the total inside basis of the partnership is equal to $100,000, your combined contributions.

However, your outside basis differs from your partner's, since your outside basis is $10,000, while that of your partner's is $50,000.

If you sold your partnership interest for $50,000, you would recognize a gain of $40,000, whereas your partner, if she sold at the same price, would recognize no gain.

There are 2 types of distributions: a current distribution decreases the partner's capital account without terminating it, whereas a liquidating distribution pays the entire capital account to the partner, thereby eliminating the partner's equity interest in the partnership.

Generally, losses are only recognized in a liquidating distribution.

No gain is recognized from a distribution of cash or marketable securities that can easily be converted to cash, unless the distribution is more than the partner's outside basis, in which case, the excess is taxable as a capital gain.

Capital Gain = Cash Distribution – Partner's Outside Basis Distributions are generally made throughout the year, but they are taken into account on the last day of the partnership's tax year.

To minimize capital gains on distributions that may be greater than a partner's equity, the basis is 1 increased by the amount of income earned during the year, then it is decreased by any distributions: any excess distribution over the partner's basis is taxable as a capital gain.

When property is distributed to a partner, then the partnership must treat it as a sale at fair market value ().

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