Partnerships—Current and Liquidating Distributions; Death or Retirement of a Partner (Portfolio 716)
This Portfolio examines the tax consequences to the partnership, distributee partner, and remaining partners upon a distribution of cash or property by a partnership to a partner.
Tax Portfolio No. 716, Partnerships — Current and Liquidating Distributions; Death or Retirement of a Partner, provides a detailed discussion of the tax consequences of distributions by partnerships to partners, including those arising from distributions of a partner’s share of the results of partnership operations, and other distributions by the partnership that do not result in termination of the distributee’s interest in the partnership even though accompanied by a change in the distributee’s and remaining partners’ shares of capital or profits and losses, whether in money or property — all called current distributions — and distributions of money or property on the withdrawal of a partner whether on death or withdrawal — called liquidating distributions. Liquidating distributions may be accompanied by other retirement payments that do not represent consideration for the withdrawing partner’s interest in partnership property, and may be deferred compensation, or other claims against past or future partnership income. When the withdrawal is a result of death, there may be other collateral income and transfer tax consequences. Distributions, usually liquidating distributions, are important components of major partnership restructurings, including divisions, mergers, incorporations, and changes in legal form.
As with all other aspects of partnership taxation, the dual nature of a partnership for tax purposes — as at times an aggregation of its partners, and at times an entity — complicates the discussion, particularly because no one, including the author, has been able to articulate a comprehensive statement of when the aggregate, and when the entity, aspect should predominate. Further complication arises because the “tax” partnership includes not only entities organized as general partnerships or limited partnerships (“LP”) under state law, but also the newer forms of limited liability partnerships (“LLP”), initially primarily for professionals, and the increasingly popular limited liability company (“LLC”). The newer forms, particularly the LLC, have many more entity characteristics, particularly when full advantage of the freedom to contract that is part of the latest revisions of the governing statutes in most commercial states is taken into account, so that it is hard to distinguish them from corporations. All but the traditional general partnership have limited liability, and a general partnership can, in most states, achieve limited liability by a simple filing to become an LLP, but, particularly for professionals that limited liability protects against vicarious liability but not against liability for one’s own malpractice, including, of course malpractice in giving advice related to partnership tax matters. All but the general partnership can also have continuity of life, centralized management and free transferability of interest, subject only to the usual practical problems of transferring interests in closely held businesses. Even the general partnership can achieve most of these characteristics by a carefully drafted partnership agreement. Nevertheless, Subchapter K has not been amended to recognize these changes. Despite these factors, the Check-the-Box regulations, Regs. §301.7701-2 and -3, recognize partnership as the default tax classification for all domestic entities that are not organized as corporations or joint stock companies, or engaged in certain regulated businesses like banking and insurance. A number of problems have emerged, particularly for LLCs treated as disregarded entities, including a controversial decision by the IRS to treat the disregarded entity as the one responsible for payroll taxes for its employees, and questions about the status of recourse liabilities of a disregarded entity, particularly one that owns a partnership interest.
This Portfolio analyzes not only the relevant statutory and regulatory materials, but also the large body of case law, revenue rulings, and other IRS pronouncements, including technical advice memoranda and private letter rulings, that are all part of this, unfortunately complex, body of tax law.
Part I, Introduction, briefly discusses important general principles not directly related to distributions, but that will nevertheless frequently be referred to throughout the Portfolio, including partnership capital accounts, §704(c) and reverse §704(c)allocations. Part I then addresses the vexing question of distinguishing a partner withdrawal from sale of a partnership interest (which are considered in more detail in 718 T.M. Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination). Part I concludes with a brief discussion of the general anti-abuse regulations. Part II discusses the principles applicable to all distributions — current and liquidating — including distinguishing between them — and the general principles for nonrecognition of gain or loss on distributions of partnership property in kind, and the effect of partnership liability shifts as part of distributions. Part III deals with the specific tax consequences of current distributions, including the basis of distributed property, the effects on the outside basis of the distributee partner’s interest of money and property distributions, and the effects on the inside basis of the partnership’s assets of in-kind distributions, as well as the effects of §751 to recharacterize non-pro rata distributions by partnerships that have §751 property and other property as taxable exchanges instead of nonrecognition distributions. The tax consequences of liquidating distributions are discussed in Part IV, including the different rules for the basis of distributed property, and the effect on the partnership’s inside basis of gain or loss recognized by the distributee partner. Finally, Part V analyzes §736, which characterizes partnership payments made to a retiring partner or the successors of a deceased partner, dividing them between those that are liquidating distributions allocable to the retiring or deceased partner’s interest in the partnership (including goodwill and similar intangibles) that are governed by the principles discussed in Part IV, and any other withdrawal payments, which are classified as either distributive share payments, with their character determined by the allocable share of partnership income, or guaranteed payments, which are ordinary income to the distributee without regard to partnership income, depending on whether their amount is determined by partnership income or not, and are, in effect, deductible (or excludible) by the partnership (remaining partners). It also addresses estate and income tax considerations relevant to a deceased partner’s successors, other than those involving §736.
Table of Contents
II. Overview of the Rules Governing Partnership Distributions
III. Tax Consequences of a Current Distribution
IV. Tax Consequences of a Liquidating Distribution
V. Special Basis Adjustment
VI. Subsequent Sales of Distributed Property
VII. Death or Retirement of a Partner – Section 736
VIII. Death of a Partner – Tax Considerations Other Than Section 736
Professor of Law Emeritus and Dean's Distinguished Scholar for the Profession Emeritus
University of Miami