Surprisingly taxable partnership distributions

By Thomas J. Sternburg, CPA, Ph.D., and Michael W. Penn Jr., Ph.D., for The Tax Adviser
December 1, 2024

In general, distributions from a partnership do not result in a taxable transaction and generally only reduce the partner’s basis in their partnership interest. Unfortunately, this is not always true, and some very unexpected taxable transactions may result from the distribution of money or property from the partnership.

Consistent with flowthrough entity treatment, taxes on partnership income are paid by partners as the income is earned, regardless of whether any income is distributed. As a result, any eventual property and/or monetary distributions, except for excess money distribution as discussed below, from a partnership generally do not create taxable income to the recipient partner.

However, multiple exceptions can create taxable income causing taxpayers problems when they are not adequately planned for, such as contributions of liabilities to a partnership or changes in the terms of a liability.

Each of the following can result in the creation of taxable income for the recipient partner, and in some cases the partnership itself will have taxable income that will flow through to the partners, even to partners who are not receiving a distribution:

• A distribution of money in excess of the basis in the partnership interest (Sec. 731(a));
• A distribution of marketable securities, as described in Sec. 731(c);
• A reduction in share of partnership liabilities, as described in Sec. 752(b);
• A distribution of property involving a disguised sale, as described in Sec. 707(a) (2)(B);
• A distribution of property with precontribution gains, as described in Secs. 704(c) and 737; and
• A disproportional distribution, as defined in Sec. 751(b).

This article discusses each of these items further and provides illustrative examples.

Distribution of money

It is always extremely important to properly track a partner’s basis in the partnership interest. Tracking basis is especially important when dealing with the distribution of money or anything that is defined to be treated as money for purposes of the Code because, under Sec. 731(a), a distribution of money will result in the creation of taxable income when a partner receives a distribution greater than the tax basis of the partner’s interest in the partnership (hereinafter, outside basis).

Unfortunately, the definition of “money” in the Code is much more expansive than just the actual distribution of currency. Distributions of “money” can include the distribution of marketable securities or a decrease in the partner’s allocated share of liabilities resulting from either a reduction in the partner’s share of partnership liabilities or from the contribution of individual liabilities to a partnership by the partner.

More detailed discussion and examples of these distributions treated as money follow, beginning with distributions of marketable securities.

Read complete article here.

Contributors

Thomas J. Sternburg, CPA, Ph.D., MAS., is a teaching assistant professor of accountancy, and Michael W. Penn Jr., Ph.D., M.Acc., is a senior lecturer of accountancy and Deloitte scholar, both in the Gies College of Business at the University of Illinois at Urbana-Champaign. For more information about this article, contact thetaxadviser@aicpa.org.