This discussion of the tax consequences of contributions to partnerships will also apply to limited liability companies unless the limited liability company has elected to be taxed as a corporation.As with S corporations, the tax consequences of a distribution to a partner are heavily dependent on the partner’s basis in his partnership interest.A partner’s initial basis in his partnership interest depends on how the partner acquired the interest.
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Unlike the rules that apply to C corporations, which tax income both at the entity and at the owner level, the partnership rules are designed to only tax income once, at the owner level.
A partnership’s income, losses, deductions, and credit are passed through to the partners for Federal tax purposes and taxed directly to them, regardless of when income is distributed. Since the partners have already paid tax on the income when it is earned, a complex system of rules applies to prevent double taxation when the income is later distributed to the partners.
These rules (a) allocate the partnership’s income, losses, deductions, and credit among the partners and (b) adjust basis to reflect each partner’s allocation of those items.
As stated in Taxation of Limited Liability Companies and Partnerships, limited liability companies are taxed as partnerships by default.
The partner’s basis in his partnership interest in increased by: These basis adjustments depend in large part on the allocation of partnership income, gains, losses, deductions, and credit among the partners.
The partnership agreement determines the allocation of these items. If the partnership agreement is silent, these items are allocated in accordance with the partnership interests. If the partnership agreement allocates partnership items among the partners, the allocation is respected as long as one of the following is true: If an allocation does not meet one of these requirements, the allocation of income, gain, loss, deduction, or credit is reallocated in accordance with the partner’s interest in the partnership. Special rules apply to allocations of property with built-in gain and loss. Important Note: The rules governing substantial economic effect are complex and must be given special consideration if the partnership agreement or operating agreement provides for allocations other than in accordance with each partner’s interest in the partnership.These adjustments to basis work with the rules governing distributions to ensure that partnership income is taxed and deductions are taken only once.A partner will not recognize gain or loss on a distribution, with three exceptions: If the partner receives an in kind distribution from the partnership (other than a liquidating distribution), the partner’s basis in the property received equals the property’s adjusted basis in the hands of the partnership immediately before the distribution (but not in excess of the partner’s basis in his partnership interest), less any money distributed in the same transaction. A partner’s basis in property distributed in kind as part of a liquidating distribution is the same as his basis in the partnership, reduced by money distributed to him in the same transaction. Important Note: Special rules apply to disproportionate distributions of partnership assets that include unrealized receivables (as defined in Code § 751(c)) and substantially appreciated inventory (as determined by Code § 751(b)(3)(A) and (d)).Disproportionate distributions of these assets aren’t treated as distributions, but as a sale or exchange of assets.Both the partnership and the partners may have income, gain, or loss as a result of proportionate distributions.No gain or loss is recognized to a partnership on a distribution of property or money to a partner. The one exception is for disproportionate distributions, which are treated as a sale or exchange by the partnership.