Liquidating cash distributions taxable
This discussion of the tax consequences of contributions to partnerships will also apply to limited liability companies unless the limited liability company has elected to be taxed as a corporation.
As with S corporations, the tax consequences of a distribution to a partner are heavily dependent on the partner’s basis in his partnership interest.
Instead of being treated as dividends, redemptions are treated as a sale or exchange of the stock by the shareholder. The distinction can be important when the long-term capital gains rates (which apply to redemptions) are higher than the tax rates on dividends.
Corporate shareholders may prefer that the distribution be treated as a dividend, allowing the corporation to take advantage of the special dividends-received deduction under Code § 243 (which allows the dividends to only be taxed once at the corporate level).
The seller-partner will recognize ordinary income to the extent that the gain from the sale of his partnership interest is attributable to unrealized receivables and inventory. The seller-partner’s capital gain or loss equals the difference between the amount the partner realizes in the sale (reduced by the portion attributable to unrealized receivables and inventory) and the seller-partner’s adjusted basis in his partnership interest (also reduced by the portion attributable to unrealized receivables and inventory). The buyer of the partnership interest will have a cost basis. By default, the buyer-partner will inherit the selling-partner’s capital account. Because partnership assets may have appreciated or depreciated in value, this usually results in a disparity between the buyer-partner’s basis in his partnership interest (outside basis) and his allocation of the partnership’s basis in each of the assets owned by the partnership (inside basis).
To resolve this disparity, Code § 754 allows the partnership to make special basis adjustments to the inside basis of the partnership assets.
Comparison to Corporations: Because no gain or loss is recognized on a distribution of money or property to a partner, partners are able to defer recognition of the gain in the appreciated property.These adjustments to basis work with the rules governing distributions to ensure that partnership income is taxed and deductions are taken only once.A partner will not recognize gain or loss on a distribution, with three exceptions: If the partner receives an in kind distribution from the partnership (other than a liquidating distribution), the partner’s basis in the property received equals the property’s adjusted basis in the hands of the partnership immediately before the distribution (but not in excess of the partner’s basis in his partnership interest), less any money distributed in the same transaction. A partner’s basis in property distributed in kind as part of a liquidating distribution is the same as his basis in the partnership, reduced by money distributed to him in the same transaction. Important Note: Special rules apply to disproportionate distributions of partnership assets that include unrealized receivables (as defined in Code § 751(c)) and substantially appreciated inventory (as determined by Code § 751(b)(3)(A) and (d)).The liquidation of a partner’s interest may represent his interest in the fair market value of the partnership’s assets, his interest in unrealized receivables, or guaranteed payments for his interest.The primary difference between C corporations and S corporations is that C corporations are taxed twice on earned income: : once at the corporate level when the income is earned, and again at the shareholder level when the income is distributed.