However, the distribution of property subject to debt out of the partnership can easily be treated as a taxable transaction despite Section 731(a).
The significant issue is that upon the distribution in complete liquidation, the adjusted tax basis for the distributed property may be less (and sometimes much less) than the tax basis in the hands of the partnership.
Whether earnings are retained in a partnership or distributed to partners has no affect on the taxation of those earnings, since the partners have to pay tax on the earnings whether they are distributed or not.
Earnings are distributed to each partner's capital account from which distributions are charged against.
As discussed on this blog previously, distributions of partnership assets in liquidation prior to exchanges by partners are commonly called “drop-and-swap” transactions.
The partnership can distribute the assets to the partners as in exchange for each partner’s interest, subject to a tenancy in common agreement.
The rules governing partnership taxation, for purposes of the U. Federal income tax, are codified according to Subchapter K of Chapter 1 of the U. Internal Revenue Code (Title 26 of the United States Code). Flow-through taxation means that the entity does not pay taxes on its income.
The outside basis is the tax basis of each individual partner's interest in the partnership.
Upon a liquidating distribution, a partner with a negative capital account must restore the capital account deficit, with certain exceptions provided in the regulations, to be paid to creditors of the partnership or distributed to partners with positive capital accounts. For example: in complete liquidation of his interest in the partnership, the release of his 50% share of the 0,000 debt is treated as a distribution of cash in the amount of 0,000 to himself. The 0,000 deemed cash distribution reduces Partner A’s initial investment in the partnership (outside tax basis) of 0,000 to zero and the excess 0,000 is treated as gain from the sale or exchange of Partner A‘s interest in Partnership AB. Furthermore, the property received has a zero tax basis.
For more information on 1031 exchanges, contact the tax attorneys at All States 1031 Exchange Facilitator at 877-395-1031.
Aggregate and Entity Concept The Federal income taxation of partners and partnerships is set forth under Subchapter K covering Sections 701–777 of the Code.
Subchapter K represents a blending of the Aggregate and Entity concepts.