Partnership distributions fall into two categories: current distributions and liquidating distributions. A current distribution provides money or property to a continuing partner. A liquidating distribution ends the partner’s entire interest, either through one distribution or a series of distributions.
A partner reports their distributive share of partnership income for the year in which the partnership’s tax year ends, regardless of when cash is distributed. A distribution itself does not create taxable income unless specific rules apply.
Hot assets may affect the character of gain. If a distribution changes a partner’s share of unrealized receivables or substantially appreciated inventory, the transaction is treated as a sale or exchange. If the partner’s share of these assets remains the same, the distribution is proportionate and the regular rules apply.
In general, distributions are a tax‑free return of capital. A partner’s outside basis is reduced, but not below zero, by the money and adjusted basis of property received.
When a Partner Recognizes Gain
A partner recognizes gain only when the money received exceeds outside basis. The gain is treated as gain from the sale of a partnership interest unless the distribution affects hot assets, in which case ordinary income rules apply.
A partner does not recognize loss on a current distribution. Marketable securities are treated as money unless the partner contributed them or the partnership qualifies as an investment partnership.
Partner’s Basis in Distributed Property
The basis of distributed property is generally the partnership’s adjusted basis immediately before distribution. However, the partner’s basis in the property cannot exceed their remaining outside basis after subtracting money received.
The partner’s holding period includes the partnership’s holding period. If the partner originally contributed the property, their prior holding period also carries over.
Liquidating Distributions
A partner may recognize a loss in a liquidating distribution, but only if the partner receives only money, unrealized receivables, or inventory. Receiving any other property prevents loss recognition.
Loss is the excess of outside basis over the sum of money and the partnership’s adjusted basis in unrealized receivables and inventory.
Basis Allocation in Liquidating Distributions
Because the partner’s outside basis must end at zero, basis is allocated to distributed property using specific ordering rules:
- Assign basis to unrealized receivables and inventory equal to the partnership’s adjusted basis. If this exceeds the partner’s available basis, reduce the assigned basis proportionately.
- Assign remaining basis to other property equal to the partnership’s adjusted basis. If the partner’s available basis exceeds this amount, increase basis for properties with unrealized appreciation.
- Allocate any remaining basis by fair market value across all remaining properties.
After allocation, the partner’s outside basis becomes zero.