Taxation of Partnership Distributions



When a partnership makes a distribution of money or properties to its partners it is generally tax free to both the partnership and the partners. A partnership is a pass thru entity for income taxes. When the entity makes income or loses money each partner reports their share of the gain or deducts their share of the loss on their individual tax returns. The income will thus have already been taxed and the distribution will not trigger additional liability. If a partner later sells the property subsequent to receiving it from the partnership, he or she will recognize taxable gain or loss on the sale.

One exception to this rule occurs when a partnership has unrealized receivables or substantially appreciated inventory. These assets have a built in gain that will generate taxable income and sometimes certain partners will want to receive a higher or lower portion of this property in order to manipulate their individual tax liability.

As an estate planning attorney I sometimes encounter partners who think of this scheme. A partner in a higher tax bracket for example may wish to take a higher percentage of assets that will generate long term capital gains when he ultimately sells them. Unfortunately I have to tell these individuals that the Internal Revenue Code has a provision to discourage this conduct. Unless unrealized receivables or substantially appreciated inventory are distributed to the partners proportionately to their partnership interest the law will treat this distribution as a sale, which can generate taxable income.