In general, the owners of a closely held business have several options by which they may withdraw money from the business without selling their interest in the business.[i] For example, an owner may:
- Receive compensation for services rendered to the business (an employee-employer, or other service-provider/service-recipient, relationship);
- Receive rent or royalty for allowing the business to use the owner’s property (a lessor-lessee/licensor-licensee relationship);
- Sell property to the business (a seller-buyer relationship); and
- Borrow money from the business (a debtor-creditor relationship).
In each of these situations, the owner is not acting as an owner;[ii] rather, they and their business are transacting with one another as they would with another third party;[iii] there is an exchange of consideration between them.
Assuming the owners of the business are not looking to sell the business, the most common means by which owners, acting in their capacity as such, may withdraw funds from the business is by causing the business to make a distribution with respect to the owners’ equity interests (a shareholder-corporation or partner-partnership relationship).[iv]
Generally speaking, a distribution of money from a business entity to an owner with respect to their equity interest may be accomplished in one of two ways: (i) a “current” distribution of money (which generally does not change the owners’ relative equity in the business); and (ii) a distribution in exchange for some of the owner’s equity in the business – basically, a partial redemption of an owner’s shares of stock, or a partial liquidation of the owner’s partnership interest.[v]
A current distribution of money is the most common type of distribution made by a business.
The timing and amount of a current distribution may vary widely from business to business. In some cases, the “manager(s)” of the business will be authorized to determine, in their discretion, if and when to make a distribution, and how much to distribute. In other cases, the owners may have agreed amongst themselves that all “available funds” must be distributed at least annually. Then there are those situations – in the case of a pass-through entity – where the only “required” distributions of money during a taxable year are those made to enable the owners to pay their quarterly estimated and year-end taxes attributable to their share of the entity’s profits. In each of these situations, every owner will generally receive a distribution based upon their relative equity in the business; in the case of a partner, their distributive share of the partnership’s net income.
Basic Partnership Taxation
Interestingly, I’ve been asked a number of questions lately regarding current distributions by partnerships; some of these may indicate a misunderstanding of how and when a partner’s basis for their partnership interest is determined.
This post will focus on the income tax treatment of a current distribution of money from a closely held partnership to a member of the partnership; specifically, the determination of the basis against which the distribution is measured.
Before delving into this narrow topic, it would be worthwhile reviewing how a partnership’s income is taxed.
A partnership – including an LLC that is treated as a partnership for tax purposes[vi] – is not subject to federal income tax;[vii] instead, its income passes through to its partners, each of whom must include their distributive share[viii] of the partnership’s income (and other tax items) on their tax return,[ix] without regard to whether any distribution has been made to the partner by the partnership.[x]
In general, a partner’s adjusted basis for their partnership interest (the partner’s so-called “outside basis”) is increased by the amount of money they contribute to the partnership and by their distributive share of partnership income.[xi]
Conversely, a partner’s outside basis is reduced, but not below zero,[xii] by the amount of money distributed to the partner and by the partner’s distributive share of partnership loss.
Distribution of Money
The net upward adjustment to a partner’s outside basis allows the partnership to subsequently distribute an amount of money to the partner equal to their distributive share of the partnership’s “taxable income” without causing the distributee partner to recognize additional income, thereby preserving the passthrough nature of the partnership for tax purposes.[xiii]
But what about a distribution of money in excess of the distributee partner’s outside basis?
In the case of a current[xiv] distribution of money[xv] from a partnership to a partner, gain will not be recognized by the partner except to the extent that the amount of money distributed exceeds the partner’s adjusted basis for their partnership interest “immediately before” the distribution.[xvi]
Any gain recognized as a result of this distribution of money will be considered as gain from the sale of the partnership interest of the distributee partner.[xvii] Such gain is generally treated as gain from the sale of a capital asset;[xviii] thus, the gain will be treated as long-term capital gain provided the partner’s holding period for their partnership interest is more than one year.[xix]
However, if any of the money deemed to have been received by the partner – in the deemed sale of their partnership interest – is attributable to unrealized receivables of the partnership, or to inventory items of the partnership, then a portion of the gain arising from the deemed sale will be treated as ordinary income.[xx]
For example, assume A becomes a partner in a law partnership. The partnership’s taxable year ends December 31, and the partnership uses the cash method of accounting.[xxi] Assume also that A is not required to make a capital contribution to the partnership – A is granted a profits interest,[xxii] meaning A will share in future profits (and appreciation) of the partnership.[xxiii] Finally, assume the partnership has no indebtedness and makes no distributions during A’s first year as a partner.
Early in A’s second year as a partner, the partnership issues a Schedule K-1 to A that reflects an allocation of $50,000 of partnership income for A’s first year. This income will be reported on A’s tax return (Schedule E of IRS Form 1040) for that year, and A’s basis for their partnership interest (the “outside basis”) – which began as zero – will be increased by $50,000 as of the end of the first year. The partnership also makes a distribution of $35,000 to A.[xxiv]
Because the amount of money distributed to A in the second year ($35,000) is less than A’s outside basis immediately before the distribution ($50,000), A does not recognize gain on the distribution, and A’s basis is adjusted downward by $35,000.
Determining Basis – When?
The foregoing seems fairly straightforward, not only because of the simplifying assumptions and the very basic facts described above, but also because the concepts are not difficult to grasp. As indicated above, in the case of a current distribution by a partnership to a partner, gain is not recognized by the distributee partner except to the extent the amount of money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. Simple, right?
Yes and no. The difficulty – at least until one realizes the issue – lies in the determination of the distributee partner’s outside basis “immediately before the distribution.”[xxv]
In the Beginning
For one thing, every partner in a partnership may have their own unique outside basis which is dependent upon how each partner acquired their interest;[xxvi] for example, one may have contributed cash to the partnership’s capital, a second contributed an appreciated asset, a third may have purchased their interest from another partner, while a fourth inherited an interest from a deceased partner. Another factor may be a partner’s “relationship” to a partnership’s indebtedness; for example, has the partner guaranteed the debt?[xxvii]
Close of the Tax Year
According to IRS regulation, “The determination of the adjusted basis of a partnership interest is ordinarily made as of the end of a partnership taxable year.”[xxviii] The regulation continues, “Thus, for example, such a year-end determination is necessary in ascertaining the extent to which a partner’s distributive share of partnership losses may be allowed.”
The taxable year of a partnership will not close (other than at the end of the partnership’s taxable year) with respect to a partner who sells or exchanges less than their entire interest in the partnership or with respect to a partner whose interest is reduced.[xxix]
The taxable year of a partnership will close with respect to a partner whose entire interest in the partnership terminates (whether by reason of death, liquidation, or otherwise). In that case, the partner will include in their taxable income for their taxable year within or with which the partner’s interest in the partnership ends the partner’s distributive share of partnership tax items for the partnership taxable year ending with the date of such termination.[xxx]
The above-referenced IRS regulation also provides that “a partner is required to determine the adjusted basis of his interest in a partnership only when necessary for the determination of his tax liability or that of any other person.”[xxxi]
Query what these instances may be, other than the normal close of the partnership’s taxable year, that require a determination of outside basis.
According to the regulation, “. . . where there has been a sale or exchange of all or a part of a partnership interest or a liquidation of a partner’s entire interest in a partnership, the adjusted basis of the partner’s interest should be determined as of the date of sale or exchange or liquidation.”[xxxii]
Specifically, the selling or liquidating partner’s outside basis is adjusted by taking into account “any further contributions” by the partner to the partnership (an increase),[xxxiii] as well as the distributions made to the partner (a decrease),[xxxiv] for the portion of the partnership’s taxable year ending on the date of the sale or liquidation (the current year).[xxxv]
Furthermore, the selling or liquidating partner’s outside basis is also adjusted for their share of partnership income and loss “for the taxable year [of the sale or liquidation] and prior taxable years.”[xxxvi] Thus, the partner’s share of income and loss for the portion of the partnership’s taxable year ending on the date of the sale or liquidation is taken into account in determining the partner’s outside basis.
It is noteworthy that the above-referenced regulations do not provide for the closing of a partnership’s taxable year with respect to a partner as of the date of a current (as opposed to a liquidating) distribution to the partner.
It is also significant that these regulations are silent as to whether a partner’s outside basis must be adjusted for the partner’s share of partnership income and loss for the portion of the partnership’s taxable year ending “as of the date of” a current distribution to the partner.[xxxvii]
Instead, the Code states that one must look at the adjusted basis of such partner’s interest in the partnership “immediately before” the current distribution for purposes of determining whether any gain must be recognized.[xxxviii]
As a whole, the foregoing indicates that a partner who receives a current distribution of money from a partnership cannot adjust their outside basis for the partner’s share of partnership income, etc., for the portion of the year ending with the date of the distribution.[xxxix] Thus, only the adjustments made for such items through the end of the immediately preceding taxable year are accounted for in determining whether the amount of money distributed to the partner in the current year is greater than the partner’s outside basis immediately before the distribution.
Let’s return to the earlier illustration but assume that A received $35,000 of distributions in total during their first year as a partner. Because A’s initial outside basis was zero (A did not make a capital contribution), any distributions made to A during their first year as a partner will be treated as having been received in connection with the sale of A’s partnership interest; accordingly, they will be taxable to A notwithstanding that, by the end of the year, A’s basis will have been increased by his distributive share of partnership income to an amount that exceeds the amount distributed during the year.
Advances or Draws
“For the purposes of sections 731 and 705, advances or drawings of money or property against a partner’s distributive share of income shall be treated as current distributions made on the last day of the partnership taxable year with respect to such partner.”
Thus, an “advance or draw” is not treated as a “current distribution” as of the time it is made.[xliii] That treatment is reserved for the end of the year, after the tax return for the year has been completed and each partner’s distributive share of partnership income, etc., has been determined and reported on such partner’s Schedule K-1.[xliv]
At that point, the partner’s outside basis is adjusted, hopefully upward, to reflect their share of the partnership’s operations for all of the current year (not only up to the date of the “advance”). It is this adjusted outside basis with respect to which the tax consequences of the deemed year-end distribution are determined.[xlv] Because this basis is presumably greater than the partner’s basis at the beginning of the year, the advance/distribution is less likely to have exceeded the distributee’s basis and result in an unwanted taxable gain.[xlvi]
But what is it about an “advance” that allows the partnership and the partner to suspend the determination of its tax consequences until the year-end? Is it a loan in part, for all intents and purposes, that must be repaid, but which is forgiven at the end of the year?
Or is its character left open until the distributee “vests” in the amount transferred to them, until it character has been established by reference to the amount of their distributive share for the entire year? What if the distributee received an amount that exceeds their distributive share?
Either way, the distributee partner to whom the advance was made should be required to return the amount by which the advance exceeds the partner’s distributive share of partnership income for the year.[xlvii]
Let’s return to our illustration.
Partner A’s initial outside basis was zero but was increased to $50,000 as of the end of A’s first year. Halfway through A’s first year, however, A received a distribution of money in the amount of $30,000. Assuming the distribution is treated as such as of the date it is made, then A’s outside basis immediately before the distribution was zero. Thus, A received money in excess of A’s outside basis and recognized gain of $30,000 in the first year.
If, instead, the $30,000 had been treated as an advance against A’s distributive share for the year, A’s outside basis would have been increased by $50,000 at the year-end before taking into account the $30,000 distribution of money. In that case, A would not recognize any gain from the distribution, and A’s outside basis would be reduced to $20,000.
What if A’s distributive share at the end of the first year was $25,000? In that case, A would have received $5,000 of money in excess of A’s outside basis as of the end of the year. However, because A received the money as an advance of A’s distributive share, A would be treated as having received a distribution of $25,000 and a loan of $5,000. The distribution would not be taxable to A but would reduce the outside basis to zero. The loan would be repaid from future partnership distributions or from A’s other assets.
Planning In “Advance”
Based on the foregoing, one might conclude that “mid-year” distributions of money by a partnership may not be such a good idea.
It depends. We saw in the illustration above how A received a current distribution of money during A’s first year as a partner. Because A had not made any capital contributions to the partnership, A’s outside basis immediately before the distribution was zero. Consequently, A recognized taxable gain as a result of the distribution, even though A’s distributive share of profits for the entire year exceeded the amount distributed.
We also saw that if the amount of money paid to A by the partnership had initially been treated as an advance against A’s distributive share of partnership income, and subsequently as a current distribution (at the end of the year, after A’s outside basis was adjusted), the distribution would not have been taxable to the extent of A’s outside basis, and any excess would have been treated as a loan from the partnership to A.[xlviii]
Unfortunately, the tax treatment of an advance payment cannot be known with any certainty until after the partnership has determined its year-end taxable income for the year in which the advance was paid, which may not occur for several months after the end of the year. This delay, however, raises the possibility of considering another option.
For instance, in some cases, a partnership may have paid the distributee partner a “greater than usual” amount of money in recognition of the partner’s having an exceptional year. In that case, the other partners may decide to retroactively adjust their distributive shares for the year to match the distributions actually made; indeed, IRS regulations provide that a partnership agreement may be modified with respect to a particular taxable year subsequent to the close of such year, but not later than the due date (not including any extension of time) for the filing of the partnership’s tax return for the year.[xlix] Such an amendment may prevent any part of the distributee’s advance from being treated as a loan that had to be repaid.
Of course, the foregoing discussion may have been much different if partner A had made a not insignificant capital contribution of money or other property at the time of A’s admission to the partnership.
For that reason, it behooves the partners to plan carefully for, and sufficiently in advance of, any withdrawals of money from their partnership that are intended to be treated as current distributions in order to avoid what would probably be a partner’s unexpected recognition of gain, or the partner’s unexpected obligation to return a portion of the amount distributed to them.[l]
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Assume for these purposes that the business is treated as a corporation (per se or elective) or as a partnership for tax purposes.
[ii] If the transactions were carried out for less than fair market value consideration, the bargain element may be treated as a constructive distribution by the business to the owner.
[iii] Hopefully. Or as close to arm’s length as reasonably possible.
[iv] In the case of a partnership distribution, it pays to be careful of the “disguised sale” rules under IRC Sec. 707, which may under certain circumstances treat the distribution as consideration paid by the partnership to the partner in exchange for property “contributed” by the partner to the partnership. See Reg. Sec. 1.707-3.
[v] A partial redemption/liquidation that is made on a pro rata basis such that the relative ownership interests do not change should not be treated as an exchange. IRC Sec. 302, IRC Sec. 751. In the case of a corporation, even where the redemption results in a change in relative ownership among the shareholders, the reduction in one’s relative interest may not be significant enough to be treated as a sale or exchange of a portion of one’s interest for tax purposes.
[vi] Reg. Sec. 301.7701-3.
[vii] IRC Sec. 701.
[viii] IRC Sec. 704.
[ix] IRC Sec. 702.
[x] Thus, partners may owe tax on partnership income without receiving any cash with which to pay such tax. This may be especially burdensome on a minority partner who does not work in the partnership’s business.
[xi] IRC Sec. 705.
[xii] Contrast the partner’s capital account, which may be driven negative by disproportionate allocations of loss or disproportionate distributions of money; the distribution of loan proceeds is often the reason for a negative capital account.
[xiii] Basically, avoiding a “double tax.” The same concept applies to S corporations. See IRC Sec. 1366, Sec. 1367, and Sec. 1368.
[xiv] All distributions by a partnership to a partner, other than distributions in liquidation of a partner’s entire interest in the partnership, are treated as current distributions. See Reg. Sec. 1.761-1(d).
[xv] Under IRC Sec. 731(c), marketable securities are generally treated as money for this purpose. There are exceptions.
In addition, under IRC Sec. 752(b), a reduction in the partner’s share of partnership liabilities – whether because of a reduction in the partner’s interest in the partnership or because of the satisfaction of the liability – is treated as a distribution of money by the partnership to the partner.
[xvi] IRC Sec. 731(a)(1).
[xvii] IRC Sec. 731(a), last sentence.
[xviii] IRC Sec. 741.
[xix] IRC Sec. 1001, Sec. 1221, Sec. 1222.
In the case of an individual partner, the maximum federal income tax rate applicable to the gain will be 20 percent. IRC Sec. 1(h). In addition, the gain may also be subject to the 3.8 percent surtax on net investment income if the partnership’s trade or business is a passive activity with respect to the partner. IRC Sec. 1411(c).
[xx] IRC Sec. 751.
[xxi] IRC Sec. 446.
[xxii] See Rev. Proc. 93-27 and Rev. Proc. 2001-43.
[xxiii] To ensure A does not participate in undistributed profits (or other partnership value) in existence at the date of A’s admission, the partnership adjusts the partners’ capital accounts to reflect every existing partner’s share of such undistributed profits (and other value) as of the day preceding A’s admission to the partnership. Reg. Sec. 1.704-1(b)(2)(iv)(f)(5)(iii).
[xxiv] Assume that the distribution of money to A does not reduce A’s share of the partnership’s so-called “hot assets,” which may be treated as a sale by A of his interest in such assets, thereby generating ordinary income. IRC Sec. 751(b)(1)(B).
[xxv] IRC Sec. 731(a)(1):
“In the case of a distribution by a partnership to a partner, gain shall not be recognized to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner’s interest in the partnership immediately before the distribution, . . .”
[xxvi] The adjusted basis of a partner’s interest in a partnership is the basis of such interest as determined under IRC Sec. 722 (relating to contributions to a partnership) or Sec. 742 (relating to transfers of partnership interests). In the case of an interest that passes from a decedent, IRC Sec. 1014 (subject to any Sec. 691 IRD items owned by the partnership), and Reg. Sec. 1.742-1 establish the successor partner’s initial outside basis.
[xxvii] Thereby causing the debt to be treated as recourse debt as to the guarantor-partner (because they bear the economic risk of loss) which, under IRC Sec. 752, would be allocated to this partner, thus increasing their outside basis. Reg. Sec. 1.752-2.
[xxviii] Reg. Sec. 1.705-1(a)(1).
[xxix] IRC Sec. 706(c).
[xxx] Reg. Sec. 1.706-1(c)(2).
[xxxi] Reg. Sec. 1.705-1(a)(1).
[xxxii] Reg. Sec. 1.705-1(a)(1).
[xxxiii] IRC Sec. 722.
[xxxiv] IRC Sec. 733.
[xxxv] IRC Sec. 705; Reg. Sec. 1.705-1(a)(2) – (3).
[xxxvi] As determined under IRC Sec. 703 and Sec. 704.
[xxxvii] See, for example, Rev. Rul. 66-94, in which the consequences of a current distribution were determined based only upon the capital contribution made by the distributee partner earlier in the year and without regard to the overall loss allocated to him at the end of the year.
[xxxviii] IRC Sec. 731(a).
[xxxix] Distributions and contributions made during this period are accounted for.
[xl] Reg. Sec. 1.731-1(a)(1)(ii).
Interestingly, this regulation later seems to distinguish between a draw or advance, on the one hand, and a loan on the other. It provides that: “The receipt by a partner from the partnership of money or property under an obligation to repay the amount of such money or to return such property does not constitute a distribution subject to section 731 but is a loan governed by section 707(a). To the extent that such an obligation is canceled, the obligor partner will be considered to have received a distribution of money or property at the time of cancellation.” Reg. Sec. 1.731-1(c)(2).
[xli] IRC Sec. 705.
[xlii] IRC Sec. 731.
[xliii] The regulations do not expand upon what is meant by an “advance.”
[xliv] “Partner’s Share of Income, Deductions, Credits, etc.”
[xlv] By contrast, the basis as of the end of the immediately preceding year would have been used if the advance had instead been treated as a distribution on the date it was made and the tax consequences thereof had to be determined as of such date.
[xlvi] According to the basis ordering rules in IRC Sec. 732(a) and Reg. Sec. 1.704-1(d), basis is increased by the partner’s distributive share of partnership income/gain for the year, then is reduced by cash distributions (followed by other distributions); it is then further reduced (but not below zero) by the partner’s distributive share of losses.
Although the ordering rule increases the likelihood that a distribution of money will not be taxable to the partner, it also reduces their ability to deduct losses. IRC Sec. 704(d).
[xlvii] Of course, a distribution that liquidates a partner’s entire interest could not be characterized as an advance or draw against partnership income, because the partnership’s tax year closes for a partner who receives a liquidating distribution for his entire partnership interest. In that case, the partner’s basis would be adjusted as of the date of the distribution.
Similarly, it is not readily apparent how a distribution accompanied by a reduction in the partner’s percentage interest in profits and losses and in capital could be treated as an advance or draw, notwithstanding it is treated as a current distribution for tax purposes and even though the partnership tax year does not close.
Still, the change may require that the income for the year be allocated to reflect the partners’ respective varying interests. IRC Sec. 706(d)(1); Reg. Sec. 1.706-1(c).
[xlviii] The repayment terms should be consistent with a real indebtedness. For example, provide for repayment from future distributions, but no later than some fixed number of years, and subject to acceleration upon certain events.
[xlix] Reg. Sec. 1.761-1(c).
[l] Such surprises, in turn, produce unhappy partners.