Last year, a real estate partnership we advised made what seemed like a routine $147,000 cash distribution to a retiring partner. Three months later, that partner received an unexpected tax bill for $62,000. The culprit? Nobody had tracked the partner’s tax basis properly, turning what should have been a tax-free return of capital into a massive taxable gain.
If you’re managing partnership distributions for 2-100 partners, this guide will help you avoid similar disasters. Partnership distributions involve complex rules under Subchapter K of the Internal Revenue Code, but with the right knowledge and examples, you can master them.
This article is part of our Complete Guide to Partnership Taxation, which covers all aspects of partnership tax strategy and compliance.
Table of Contents
What You’ll Learn in This Guide
- The fundamental difference between current and liquidating distributions
- How to calculate tax consequences with 15+ real-world examples
- When distributions trigger gain (and why they never trigger loss)
- Section 751 “hot assets” that convert capital gains to ordinary income
- Common $10,000+ mistakes and how to prevent them
- Free tools and calculators to simplify distribution planning
This comprehensive guide focuses on practical application rather than academic theory, giving you the tools to handle partnership distributions correctly the first time.
What Are Partnership Distributions?
Partnership distributions represent the transfer of cash or property from a partnership to its partners. Unlike corporate dividends, which are generally taxable, partnership distributions follow unique tax rules that can make them tax-free, partially taxable, or fully taxable depending on specific circumstances.
The Legal Framework
Under Subchapter K of the Internal Revenue Code, partnerships are pass-through entities. Partners pay tax on their share of partnership income whether distributed or not. This creates a fundamental principle: distributions are generally returns of previously-taxed capital, not new income.
Types of Partnership Distributions
Partnerships make two primary types of distributions:
- Current Distributions (Operating Distributions) – Partial distributions that don’t terminate a partner’s interest
- Liquidating Distributions – Complete redemption of a partner’s entire partnership interest
Example 1: Simple Cash Distribution ABC Partnership distributes $50,000 cash to Partner John, who has a $100,000 tax basis and continues as a 25% partner. This is a current distribution. John’s basis reduces from $100,000 to $50,000. No gain or loss is recognized. The distribution is completely tax-free.
The distinction between current and liquidating distributions determines the applicable tax rules, potential for loss recognition, and basis adjustment mechanics.
Current Distributions: The Day-to-Day Reality
Current distributions, also called operating distributions, occur when partnerships distribute cash or property to partners who continue their ownership. These represent the most common type of partnership distribution, typically occurring quarterly or annually.
Tax-Free Treatment Under Section 731
The general rule under Section 731 provides that partners don’t recognize gain or loss on current distributions. However, this tax-free treatment only applies to the extent of the partner’s basis in the partnership interest.
Example 2: Tax-Free Distribution Within Basis XYZ Partnership makes the following distribution to Partner Sarah:
- Cash distributed: $100,000
- Sarah’s tax basis before distribution: $150,000
- Tax consequence: $0 (completely tax-free)
- Sarah’s basis after distribution: $50,000
The distribution is tax-free because it doesn’t exceed Sarah’s basis. Her basis reduces dollar-for-dollar by the cash received.
When Current Distributions Trigger Gain
Gain recognition occurs when cash distributions exceed the partner’s tax basis. Importantly, only cash distributions can trigger gain in current distributions – property distributions cannot.
Example 3: Distribution Exceeding Basis Tech Partnership distributes $100,000 cash to Partner Mike:
- Cash distributed: $100,000
- Mike’s tax basis before distribution: $75,000
- Gain recognized: $25,000 (capital gain)
- Mike’s basis after distribution: $0
Mike must report $25,000 of capital gain because the cash exceeds his basis by that amount. The character of the gain (long-term or short-term) depends on Mike’s holding period in the partnership interest.
The No-Loss Rule for Current Distributions
A critical rule: partners cannot recognize loss on current distributions, regardless of the circumstances. This asymmetry catches many partners by surprise.
Example 4: Multiple Distributions Throughout the Year Real Estate Partnership makes quarterly distributions to Partner Janet:
- Q1: $30,000 cash (basis before: $200,000, after: $170,000)
- Q2: $40,000 cash (basis before: $170,000, after: $130,000)
- Q3: $50,000 cash (basis before: $130,000, after: $80,000)
- Q4: $100,000 cash (basis before: $80,000, after: $0, gain: $20,000)
Total distributions: $220,000 Total gain recognized: $20,000 (in Q4 only)
Basis Reduction Mechanics
The order of basis reduction follows specific rules under Section 733:
- Cash reduces basis dollar-for-dollar
- Ordinary income property reduces basis by the partnership’s basis
- Other property reduces remaining basis
Example 5: Mixed Cash and Property Distribution Manufacturing Partnership distributes to Partner Robert:
- Cash: $40,000
- Inventory (FMV $30,000, partnership basis $20,000)
- Equipment (FMV $25,000, partnership basis $15,000)
- Robert’s basis before distribution: $100,000
Basis reduction calculation:
- Cash reduction: $100,000 – $40,000 = $60,000
- Inventory reduction: $60,000 – $20,000 = $40,000
- Equipment reduction: $40,000 – $15,000 = $25,000
- Robert’s remaining basis: $25,000
Liquidating Distributions: The Exit Strategy
Liquidating distributions occur when a partner completely exits the partnership. These distributions follow different rules than current distributions and can trigger both gains and losses.
Key Differences from Current Distributions
- Loss Recognition Allowed: Partners can recognize loss if they receive only cash, unrealized receivables, and inventory
- Basis Allocation: Different ordering rules apply
- Character of Gain/Loss: May be ordinary or capital depending on assets received
- Holding Period: Includes partnership’s holding period for distributed assets
Example 6: Simple Liquidating Distribution Partner Amy exits DEF Partnership:
- Cash received: $50,000
- Amy’s basis: $80,000
- Loss recognized: $30,000 (capital loss)
Amy recognizes a $30,000 capital loss because she received only cash less than her basis.
Complex Liquidating Distributions
When partners receive property in liquidating distributions, basis allocation becomes complex.
Example 7: Property Liquidating Distribution Partner Carlos exits GHI Partnership:
- Cash received: $20,000
- Real estate (FMV $100,000, partnership basis $60,000)
- Carlos’s basis: $90,000
Basis allocation:
- Cash takes basis first: $90,000 – $20,000 = $70,000
- Real estate receives remaining basis: $70,000
- Carlos’s basis in real estate: $70,000
- No gain or loss recognized on distribution
Section 751: The “Hot Asset” Trap
Section 751 prevents partners from converting ordinary income into capital gains through distributions. “Hot assets” include unrealized receivables and substantially appreciated inventory.
Identifying Hot Assets
Unrealized Receivables include:
- Accounts receivable (cash-basis partnerships)
- Depreciation recapture potential
- Market discount bonds
- LIFO inventory recapture
Inventory Items include:
- Traditional inventory
- Any property that would not be capital assets or Section 1231 property if sold
Example 8: Hot Asset Distribution Service Partnership distributes to Partner David:
- Cash: $100,000
- Accounts receivable (FMV $50,000, basis $0)
- David’s basis: $120,000
Tax treatment:
- The receivables are “hot assets” under Section 751
- David is deemed to purchase the receivables for $50,000
- Ordinary income of $50,000 when collected
- Capital gain on remaining distribution
Disproportionate Distributions
Section 751(b) applies when a partner receives more or less than their proportionate share of hot assets.
Example 9: Disproportionate Distribution Triggering Section 751(b) Partner Ellen owns 50% of JKL Partnership, which has:
- Cash: $200,000
- Inventory (FMV $200,000, basis $100,000)
- Ellen receives $200,000 cash (no inventory)
Tax consequences:
- Ellen’s share of inventory: $100,000 FMV
- Deemed exchange: Ellen “sells” inventory interest for cash
- Ordinary income: $50,000 (her share of built-in gain)
- Remaining distribution treated as normal
Common Distribution Mistakes and Their Costs
Mistake #1: Ignoring Basis Tracking
The Problem: Many partnerships fail to track each partner’s basis accurately, leading to surprise tax bills.
Example 10: The Basis Tracking Disaster Tech Startup Partnership never tracked basis. Partner Frank receives $500,000 distribution:
- Frank’s assumed basis: $500,000
- Frank’s actual basis (properly calculated): $200,000
- Unexpected taxable gain: $300,000
- Additional tax owed: $71,400 (at 23.8% capital gains rate)
The Solution: Maintain detailed basis schedules updated after every transaction.
Mistake #2: Mishandling Debt Allocations
Partnership debt affects partner basis. Changes in debt allocation can trigger deemed distributions.
Example 11: Debt Reduction Triggering Gain Partner Grace’s share of partnership debt decreases from $300,000 to $100,000:
- Deemed cash distribution: $200,000
- Grace’s basis before: $150,000
- Gain triggered: $50,000
Mistake #3: Ignoring State Tax Implications
Different states have varying rules for partnership distributions.
Example 12: Multi-State Tax Trap Partner Henry receives a $1 million distribution:
- Federal tax: $238,000 (properly planned)
- California surprise tax: $133,000 (not planned)
- Total tax: $371,000 vs. expected $238,000
Advanced Distribution Strategies
Timing Distributions for Tax Efficiency
Strategic timing can significantly reduce tax burdens.
Example 13: Year-End Planning Partner Isabel expects lower income next year:
- Distribution if taken December 2024: $50,000 tax
- Distribution if taken January 2025: $35,000 tax
- Tax savings from waiting: $15,000
Using Special Allocations
Partnerships can use special allocations to optimize distributions, subject to substantial economic effect rules.
Example 14: Special Allocation Strategy MNO Partnership allocates depreciation to high-income Partner Jack:
- Jack’s additional depreciation: $100,000
- Tax savings for Jack: $37,000
- Other partners receive larger cash distributions
Mixing Cash and Property Distributions
Strategic mixing of cash and property can minimize taxes.
Example 15: Optimized Mixed Distribution Partner Kelly needs $200,000 value:
- Option A: All cash (triggers $50,000 gain)
- Option B: $150,000 cash + property worth $50,000 (no gain)
- Tax savings: $11,900
Tools and Resources for Distribution Planning
Essential Calculations
Basis Tracking Formula:
Beginning Basis
+ Share of Income
+ Share of Tax-Exempt Income
+ Additional Contributions
- Distributions
- Share of Losses
- Share of Nondeductible Expenses
= Ending Basis
Documentation Requirements
Maintain these records for every distribution:
- Partnership agreement provisions
- Board/partner approval documentation
- Basis calculations before and after
- Fair market value appraisals for property
- Section 751 hot asset analysis
- State tax implications analysis
Professional Resources
Key IRS guidance:
- IRC Sections 731-737: Distribution rules
- IRC Section 751: Hot asset provisions
- Treasury Regulations §1.731-1 through §1.737-5
- Revenue Ruling 84-53: Debt allocation changes
- Revenue Ruling 94-4: Mixing bowl transactions
Frequently Asked Questions
When are partnership distributions taxable?
Partnership distributions are generally tax-free to the extent of your basis. Gain is recognized only when cash distributions exceed your basis. Property distributions typically don’t trigger gain in current distributions.
How do I calculate my partnership basis?
Start with your initial investment, add your share of income and additional contributions, subtract your share of losses and distributions. Debt allocated to you increases basis; debt reductions decrease it.
What’s the difference between current and liquidating distributions?
Current distributions are partial payouts where you remain a partner. Liquidating distributions completely terminate your partnership interest. Only liquidating distributions can trigger loss recognition.
How do Section 751 hot assets affect me?
Hot assets (unrealized receivables and inventory) can convert what would be capital gain into ordinary income. If you receive a disproportionate share of hot assets, you may recognize ordinary income.
Can I control the timing of distribution taxation?
Yes, to some extent. You can time when to receive distributions, choose between cash and property, and work with the partnership on year-end planning. However, deemed distributions from debt changes are harder to control.
Conclusion
Partnership distributions are complex but manageable with proper planning and documentation. The key is understanding the fundamental rules: distributions are generally tax-free up to your basis, only cash can trigger gain in current distributions, and hot assets require special attention.
Most costly mistakes stem from poor basis tracking, ignoring debt allocations, or overlooking state taxes. By maintaining accurate records, planning distributions strategically, and seeking professional help for complex situations, you can minimize taxes and avoid surprises.
Remember, every partnership distribution is unique. While this guide provides comprehensive coverage of the rules and common scenarios, your specific situation may involve additional complexities. When in doubt, consult with a qualified tax professional who can analyze your particular circumstances.
Need Professional Guidance?
Navigate partnership distributions with confidence. Schedule a consultation with our experienced team.