As a general rule, a distribution to a partner from a partnership is treated as:
The correct answer and explanation is:
Correct Answer:
A distribution to a partner from a partnership is generally treated as a non-taxable return of capital to the extent of the partner’s outside basis in the partnership interest.
Explanation (Approx. 300 words):
Under U.S. tax law, partnerships are treated as pass-through entities, meaning that income, deductions, and credits pass through to the partners and are reported on their individual tax returns. When a partnership makes a distribution to a partner, the tax treatment depends on several factors, but the general rule is that the distribution is not taxable unless it exceeds the partner’s outside basis.
Outside basis refers to a partner’s tax basis in their partnership interest. This basis is initially determined by the amount of cash and the adjusted basis of any property contributed to the partnership, and it is increased by the partner’s share of income and decreased by distributions and losses.
Types of Distributions:
- Non-liquidating distributions (current distributions):
- These are made during the life of the partnership.
- Generally not taxable unless the distribution exceeds the partner’s outside basis.
- If the distribution includes property, it is typically taken at the partnership’s adjusted basis (i.e., no gain or loss is recognized).
- Liquidating distributions:
- Occur when a partner’s entire interest is being redeemed or the partnership is winding up.
- Similarly, no gain is recognized unless the distribution exceeds the partner’s outside basis.
- Loss may be recognized if only cash, unrealized receivables, and inventory are received and the amount is less than the partner’s basis.
Key Point:
The goal of this rule is to ensure that partners are not taxed twice—once on income they’ve already paid tax on, and again when they receive the cash. Therefore, distributions up to the partner’s basis are considered a return of investment and not income. Only distributions above that basis trigger taxable gain.