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P2-U11 Ā· Part 2 Ā· Source cycle 2026-2027

Partnership Distributions and Liquidations

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Partnership Distributions & Liquidations (2025)

Distribution Types

Current Distributions

  • Made during ongoing partnership operations
  • Do NOT terminate partner's partnership interest
  • Generally used to distribute profits or return capital
  • Generally non-taxable unless cash distribution exceeds partner's outside basis

Liquidating Distributions

  • Terminate partner's entire partnership interest
  • Occur when partner exits or partnership dissolves
  • Partner may recognize capital gain or loss depending on distribution vs. basis

Effect on Partner's Basis

Partner's adjusted outside basis is reduced by (but not below zero):

  • Cash received
  • Adjusted basis of property received

Cash distribution exceeds basis ā†’ excess = capital gain (generally long-term) Property distribution exceeds outside basis ā†’ no taxable gain, but partner's outside basis transfers to the assets received

Gain Recognition Rules

Situation Result
Cash ā‰¤ outside basis No gain; reduce basis by cash amount
Cash > outside basis Capital gain on excess
Property distribution (basis ā‰¤ outside basis) No gain; partner takes partnership's basis in property
Property distribution (basis > outside basis) No gain; partner's outside basis carries over to property
Mixed distribution (cash + property) Reduce basis by cash first, then by property basis

Loss Recognition Rules

Current (Non-Liquidating) Distributions

  • NO loss can be recognized in current distributions

Liquidating Distributions

Loss can be recognized ONLY if ALL three conditions met:

  1. Partner's adjusted basis exceeds total distribution received
  2. Partner's entire partnership interest is liquidated
  3. Distribution consists ONLY of cash, unrealized receivables, and/or inventory items

Unamortized expenses: If partnership liquidates/dissolves with unamortized organizational or start-up costs ā†’ unamortized amount deductible on partnership's final return.

"Hot Assets" ā€” Ā§751

Definition

Assets that generate ordinary income:

  • Unrealized receivables: unbilled services, depreciation recapture potential
  • Substantially appreciated inventory: FMV >120% of basis AND >10% of total partnership assets

Tax Treatment

  • Partner receiving hot asset distribution ā†’ when later sold, gain/loss treated as ordinary income/loss
  • 5-year holding rule: If partner holds distributed inventory ā‰„5 years, AND it becomes a capital asset in partner's hands ā†’ gain treated as capital gain

Sale of Partnership Interest

  • Generally capital gain/loss
  • Exception: Amount attributable to hot assets = ordinary income
  • If relieved of partnership debt ā†’ debt relief added to amount realized
  • Gain/loss = amount realized (including debt relief) āˆ’ adjusted outside basis

Related Party Transactions

Loss Disallowance

  • Losses on property sales/exchanges between partnership and related parties NOT deductible
  • Related parties: individuals owning >50% of partnership capital/profits; family members (siblings, spouses, ancestors, lineal descendants)
  • Two partnerships with same >50% owners ā†’ losses between them disallowed

Future Sale to Non-Related Party

  • Buyer can use disallowed loss to offset future gain when selling to non-related party
  • Cannot create or increase loss

Partnership Termination & Liquidation Process

Liquidation Process

  1. Partnership pays existing debts and liabilities
  2. Remaining assets distributed to partners
  3. Partner's basis in property received from liquidating distribution = adjusted partnership interest basis āˆ’ cash received in same transaction

Partner Death

  • Ends deceased partner's partnership tax year (final K-1 issued)
  • Does NOT end other partners' tax year or partnership's tax year

Termination Conditions

Partnership terminates when:

  • All business ceases AND
  • No business, financial operations, or risk activities continued by any partner in partnership form

If terminates before regular year-end:

  • Short tax year Form 1065 required
  • Due date: 15th day of 3rd month after termination date

Cancellation of Another Partner's Debt

Debt Payment

If partnership terminates and a former partner is bankrupt and cannot pay their share of partnership debt:

  • Other partners may be forced to pay more than their share
  • Paying partner can deduct bad debt on personal return

Debt Cancellation Exclusion

  • COD exclusion applies at partner level, not partnership level
  • Individual partner must be personally bankrupt to use bankruptcy exclusion for COD income passed from bankrupt partnership
  • If using exclusion ā†’ must reduce specific tax attributes

Key Connected Rules

  • Partnership Formation & Operations ā†’ See partnerships.md
  • Ā§754 Election: Optional basis adjustment for transferee partner (reported on partnership return)
  • Partner basis tracking: See partnerships.md (Outside Basis section)