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Partnership distribution (Overview: All You Need To Know)

What is a partnership distribution?

What types of distributions are there?

How are the partnership distributions taxable?

We will define partnership distributions, look at what it is, how they are taxed, current distributions, distributions in excess of basis, distribution types, distributions vs dividends, unequal distribution and more!

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What is a partnership distribution 

A partnership distribution is when the partnership transfers cash or property to a partner.

The payout can be in the form of capital payment or income.

Partnerships are business structures allowing pass-through taxation.

In other words, the partnership’s business income flows down to the partners and is taxed only once in the partners’ hands.

This distinguishes partnerships from corporations as they can avoid double taxation.

Whether or not the partnership retains earnings in the business or pays distributions to the partners, the partners must pay taxes on the business earnings in proportion to their interest.

As such, business income, losses, deductions and credits are reported by the partners on their personal income tax return.

However, this is where the partnership taxation and distributions may get tricky.

Since the partners have already paid taxes on the partnership earnings (distributed or not), it’s important that distributions to the partners do not get taxed twice in the event they were already accounted for in the partners’ income taxes.

A partnership distribution can be made in the form of cash or property, it can be paid directly to the partner or reduce the partner’s liabilities or debt towards the partnership.

Certain types of transactions may be considered a distribution such as:

  • Distribution of unencumbered property
  • Distribution for the partial liquidation of partner interests
  • The admission of a new partner 

Partnership distribution definition 

According to The Tax Adviser, a partnership distribution can be defined as:

A distribution is a transfer of cash or property by a partnership to a partner with respect to the partner’s interest in partnership capital or income.
Author

In essence, partnership distributions are sums of money or property transferred or paid by the partnership to a partner in capital payments or income.

Partner distribution types 

There are also two types of distributions, current distribution or a liquidating distribution.

Current distribution 

The current distribution reduces the partner’s capital account but does not retire the partner’s interest in the partnership.

When a partner draws money from the partnership to pay himself or herself an income, it is considered a current distribution. 

Liquidating distribution 

On the other hand, a liquidating distribution terminates the partner’s capital account.

In this case, the partner receives a distribution that eliminates the partner’s interests in the partnership.

Once a liquidating distribution is paid out, the partner’s capital account is fully bought out.

Preferred distributions 

Partners can decide, in their partnership agreement, to allocate a preferential distribution to the partners.

Depending on how the preferred distributions are structured, the tax treatment may be different.

To give you a quick overview, here is how the preferred distributions can be structured and taxed:

  • Preferred distribution guaranteed along with guaranteed return on capital on which the preference is calculated (may be treated as interest on a loan)
  • Preferred distribution guaranteed but not the return on capital on which the preference is calculated (may be treated as a guaranteed payment)
  • Preferred distribution relating to partnership property (may be treated as a sale)
  • Non-guaranteed preferred distribution (may be treated as partnership distribution)

Property distributions 

Partnership distribution of property (or property distributions) is when partners receive partnership property instead of cash.

When a property is distributed to the partners instead of cash, the partner’s basis in the property is equal to the partnership’s adjusted basis in the property before the current property distribution was made.

Are partnership distributions taxable

The partnership earnings are taxable in the hands of the partners.

It does not matter that the partnership retains its earnings or distributes them to the partners.

No matter what, the partners will need to pay taxes in proportion to their capital or interest with regard to business income.

However, once the partners have paid taxes on the business income, it’s important that the same business income is not taxed a second time if it is eventually distributed to the partners.

Also, certain types of partner distributions can exceed the partner’s basis and result in capital gains or losses to the partner.

Partner tax basis 

Distributions to partners are driven mainly by the partner basis in the partnership interests.

There are two types of taxes basis concerning partnerships:

  • Inside basis
  • Outside basis

An inside basis is the partnership’s tax basis whereas the outside basis is that tax basis applicable to each partner individually.

When the partner initially acquires interests in the partnership, he or she will be allocated a tax basis.

The partner’s basis cannot go below zero but can fluctuate over time.

The partnership basis rules are intended to prevent partners from being taxed twice.

The partner’s basis allocation will depend on how the partner acquired interests in the partnership:

  • Purchase of interest 
  • Contribution to the partnership
  • Exchange of services 

A partner’s basis can increase and decrease over time when certain events occur.

The partner basis will typically increase when:

  • The partners make additional contributions to the partnership in property 
  • The partners purchase additional interests of the partnership in cash 
  • A partner’s share in the partnership liability increases 
  • When taxable and tax-exempt income is allocated to the partner

The partner basis will typically decrease when:

  • There are distributions from the partnership 
  • The partner’s adjusted basis is sold or transferred
  • There is a decrease in the partner’s share of partnership liabilities 
  • There are losses and deductions passed to the partner 
  • There are nondeductible partnership expenses 
  • There are cash withdrawals 

Partnership withdrawals 

Partners withdrawing from the partnership are not taxed to the extent the withdrawal is a return of the partner’s investment.

In other words, any return or withdrawal paid to the partner up to and including the partner’s capital investment will be non-taxable for the partner.

However, any distributions in excess of basis or the partner’s investment will be taxable.

It’s important to keep proper accounting for partnership distribution to ensure that the partners benefit from the pass-through taxation regime without ending up paying tax twice or ending up paying taxes twice on the same dollar.

Unequal partnership distributions 

A partnership agreement may provide for an unequal partnership distribution of profits regardless of the partners’ capital contribution.

This is a flexible type of tax arrangement that is not possible for corporations like an S Corporation.

An S Corporation must distribute its earnings to its shareholders based on the percentage of stock ownership.

However, a partnership can distribute a percentage of business earnings in excess of the partners’ basis.

The reverse is also true.

Partnership losses in excess of a partner’s basis can be distributed in accordance with the partnership agreement.

Partnership distributions vs dividends

At first glance, distributions and dividends may appear to be similar or substantially the same.

However, they are not quite the same thing and do not produce the same tax consequences.

Dividends are treated as a share of a company’s profits.

Distributions are considered to be a payout of company equity.

Dividends do not impact or original cost basis when the stocks were purchased whereas distributions affect both the cost basis and taxation.

Partnership distribution vs loan 

It may not be easy to distinguish a partner distribution from a loan granted to the partner in some cases, in some cases.

From a tax point of view, it’s not how the partnership or partner characterizes the payment but rather its substance that will determine if the payment was a loan or a distribution.

Typically, an advance to a partner (or a loan) has the following characteristics:

  • The partner has a legal obligation to pay back the sums received
  • There is a repayment date or payment specifications surrounding when the money has to be reimbursed 
  • The obligation to pay back is legally enforceable 

In some cases, a proper loan may have been granted to a partner by the partnership and eventually cancelled. 

The cancellation of the loan will be deemed to be a distribution for tax purposes. 

IRS Publication 541

The IRS publishes various publications providing guidance and explanations with regards to tax laws and regulations applicable to businesses.

Publication 541 is an IRS publication providing partnership guidance and explanation on how they are taxed.

In Publication 541 the IRS provides:

  • Explanation of the partnership distribution rules applicable to U.S.-based partnerships
  • How income is produced by partnerships 
  • How partnership distributions are handled
  • Transactions between the partnership and the partners
  • Disposition of partnership interests 
  • Explanation about the 1982 Tax Equity and Fiscal Responsibility Act

Partnership distribution FAQ

Partnership distribution FAQ

Are partnership distributions considered income

Whether or not a partnership makes distributions to the partners, each partner will be taxed on the partnership’s business income.

A partnership, unlike a corporation, is not taxed separately and is not subject to income tax.

Instead, the partners report the partnership’s income on their personal income tax.

As a result, a distribution will not necessarily be considered as a taxable income when the partner had already paid taxes on the same income.

Where do you report partnership distributions

Each partnership must file an information return Form 1065.

By filing this information return, the partnership discloses its income, deductions and credits on Schedule K.

The partners will then use Form 1065 to properly allocate the business income on their own personal income tax return.

A partnership may flow down different types of income or losses to the partners such as:

  • Business profits or losses
  • Real estate income or rental revenue or losses
  • Capital gains or losses
  • Charitable contributions
  • Interest expenses 

Typically, each partner will receive a Schedule K-1 showing his or her personal income or losses passed down from the partnership.

Can partners take unequal distributions

Yes, partnerships can make unequal distributions to the partners.

This is an advantage offered by the partnership structure that is not available in corporations such as an S Corp.

The partnership agreement can essentially provide that a partner receives distributions in a proportion different from the partner’s capital contribution.

For example, if a partnership is equally owned by two partners (50%), then the partnership agreement can provide that one partner may get 40% of the earnings and losses whereas the other partner gets 60% of the same.

How do you calculate basis in a partnership

The partner’s basis allocation will depend on how the partner acquired interests in the partnership:

  • Purchase of interest 
  • Contribution to the partnership
  • Exchange of services 

A partner’s basis can increase and decrease over time when certain events occur.

The partner basis will typically increase when the partner makes further contributions to the partnership in property or cash or increases share in the partnership liability.  

The partner basis will typically decrease when the partner makes cash withdrawals, incurs nondeductible expenses or his or her share in the partnership liabilities decrease. 

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