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John O. Everett, Ph.D., CPA
Cherie J. Hennig, Ph.D., M.B.A.
Nancy Nichols, Ph.D., CPA

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Contemporary Tax Practice
Tax Tutorial Module 1 — Partnership Taxation

Topic 6: Nonliquidating and Liquidating Partnership Distributions
[IRS Materials: Publication 541]

D. Liquidating Partnership Distributions – General Recognition Rules

1. A liquidating distribution is a distribution or a series of distributions that terminates a partner’s interest in the partnership. The liquidating distribution may be in the form of a payment as part of the liquidation of the whole partnership, or the distribution may be to a retiring partner or deceased partner’s estate. In the latter case, special rules will apply.

2. Payments as Part of the Liquidation of an Entire Partnership:

  • Generally, gain is recognized only if money (cash and marketable securities) is distributed that exceeds the basis in the partnership interest before the distribution. The partner’s basis of his or her interest is determined at the time of the distribution.
  • Also, loss is recognized only if (1) the adjusted basis of the partner’s interest exceeds the distribution, (2) the partner’s entire interest is liquidated (e.g., a liquidating distribution), and (3) the distribution is only in money, unrealized receivables, or inventory items.
  • Once again, these results ignore the implications of Sec. 751 assets. Since this topic has not been tested on liquidating distributions, we will defer discussion of this until the next topic (Topic 24, Sale of a Partnership Interest).

3. Payments to a Retiring Partner or a Deceased Partner’s Estate:

  • Payments made in liquidation of the interest of a retired or the successor in interest of a deceased partner may have to be allocated between payments (1) in liquidation of the partner’s interest in partnership property and (2) “other payments.” The retiring partner is treated as a partner until the interest is completely liquidated.
  • Payments made in liquidation of the partner’s interest in partnership property are treated as a distribution under the rules for complete liquidations discussed above; these are not distributive shares of income or guaranteed payments. In most cases, any gain or loss on the liquidation of the partnership interest is reported as capital gain or loss, as a partnership interest is generally treated as a capital asset. Special tax treatments may apply for unrealized receivables and goodwill to cause the recognition of some ordinary income; this is discussed later.

Example – Jay Rohr retires from the ABC Partnership. The partnership has no unrealized receivables or outstanding liabilities. Jay’s basis of his 1/3 partnership interest is $50,000, and the value of this interest is $80,000. If Jay retires from the partnership by receiving an $80,000 cash payment, all payments are in liquidation of the partnership interest only (there are no “other payments”), and Jay will report a capital gain of $30,000 on liquidation of the interest (since “money” received exceeds his basis). If Jay had received property instead of cash, no gain would be recognized.

  • Other payments are payments in excess of payments made in liquidation of the partnership interest. These payments are treated either as distributive shares of income (if based on partnership income) or guaranteed payments (payment is not dependent on income), and as such, are usually subject to self-employment tax. Payments treated as distributive shares of income retain the same character to the partner as in the hands of the partnership. Any guaranteed payments are treated as ordinary income by the partner and are deductible by the partnership.

Example – Assume the same facts as above example, except that Jay retires from the partnership for $100,000 cash. In this case, $80,000 of the total is treated as being in liquidation of the partnership interest, resulting in the $30,000 capital gain described above. However, the remaining $20,000 is ordinary income, treated as an income distribution if dependent on income. If this amount is not dependent on income, it will be a guaranteed payment deductible by the partnership.

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