Possible Tax Traps on Partnership Distributions

Partnerships and limited liability companies are a very tax favorable business entity to conduct a family business or new enterprise.  However, depending on the type of asset distributed, the partner who made the initial contribution and who is receiving the distributed asset can have some surprising results as discussed below.

Also, family limited partnerships (FLPs) have served as a popular estate planning tool over the last decade by providing individuals valuation discounts, creditor protection, ownership continuity, and family wealth management opportunities.

At inception, many business owners or families do not consider the tax traps waiting for them when the inevitable occurs: the day when one or more members/partners want to withdraw from the entity and take a portion of the business’s assets with them. When this happens, avoiding tax can be surprisingly complex, and the entire transaction requires careful analysis.

Most tax advisors know that partnership contributions and distributions usually occur tax-free. IRC 731 generally allows a current or liquidating distribution to a partner to be tax-free unless he or she receives money that exceeds the tax basis of his or her partnership interest. Money, as discussed below, may sometimes include marketable securities. If the distribution consists solely of property other than money, the partner will not recognize taxable income.

The key difference between a current and a liquidating property distribution is the partner’s tax basis in the asset or assets received. In a current distribution, an asset has the same basis as it had in the hands of the partnership. In a liquidating distribution, the asset has a basis equal to the partner’s basis in his or her partnership interest, less any money received, plus any income recognized under IRC 731

Thus, generally, only money distributions can create gain or loss. Property distributions result in no immediate income or loss. Any inherent gain or loss will be recognized on a subsequent sale of the property by the recipient partner. However, there are several complex rules, popularly known as the “mixing bowl” rules, which need to be navigated when making property distributions. Each of them may require a partner to recognize taxable income, even in a family context.  I will deal only with where a property distribution to one partner can create taxable income for another partner who contributed the property.

The contributing partner doesn’t report the “built-in-gain” on the property when it’s contributed. The partnership takes the same basis in the property that the partner had, and the partner’s basis in the partnership interest received for the property is equal to the pre-contribution basis in the property.

Example (1). John contributes land with a basis of $10,000 and a value of $16,000 to a partnership in exchange for a 50% partnership interest. John doesn’t recognize gain. The partnership’s basis in the land and John’s basis in his interest are both $10,000.

Although the gain isn’t recognized by the contributing partner at the time of the contribution, the parties must keep track of the built-in gain so it can be specially allocated to the contributing partner when the partnership sells it. Only the gain in the property when it’s contributed is specially allocated. Any later, additional gain is allocated according to the partnership agreement.

Example (2). In Example (1), the partnership sells the property for $18,000, incurring a gain of $8,000, since its basis was $10,000. The $6,000 of built-in gain is allocated to John. The remaining $2,000 of gain (representing appreciation that occurred while the partnership owned the property) is allocated equally between John and the other partners.

Conclusion.  Any attempt to liquidate a FLP should be executed with a high degree of planning. Consultation with a tax advisor is strongly advised. The applicable rules are complicated and should be analyzed in detail. Otherwise, unsuspecting families may face an unexpected and unwelcome tax liability.