A
partner’s distributive share of any item of income, gain, loss,
deduction, or credit is generally determined by the partnership agreement.
The distributive share is usually the same as the partner’s capital
interest in the partnership or percentage of ownership in the partnership. A capital interest
in a partnership is an interest in its assets that would be distributable
to the partner if the partner withdrew from the partnership, or if the
partnership were to liquidate. The mere right to share in the earnings and
profits is not a capital interest in the partnership. However, the partnership agreement can
allocate income, gain, loss, deductions, or credits to partners in a
manner other than based on the ownership percentage; provided the
allocation method has substantial economic effect. If the partnership
agreement does not provide for a special allocation method, the allocation
of each item must be based on the partner’s ownership percentage in the
partnership.
Substantial Economic Effect: An
allocation has substantial economic effect if both of the following apply:
1) There is a reasonable possibility that
the allocation will substantially affect the dollar amount of the partners’
shares of partnership income or partnership loss independently of tax consequences,
and
2) The partner to whom an allocation is
made actually receives the economic benefit or bears the economic burden
corresponding to that allocation.
Partnership Distributions
Cash withdrawals are generally not taxable
since the partner reports and pays tax on his/her distributive share of
partnership income, even if the income has not yet been distributed to the partner. A
partnership distribution is taxable when it is treated as a guaranteed payment, or if
the distribution is considered a liquidation or sale of part or all of a
partner’s capital interest in the partnership. A distribution in excess of a partner’s
basis is also taxable.
Partnership Losses
A partner’s distributive share of
partnership losses
is allowed up to the partner’s adjusted basis in the partnership. Basis
generally includes the partner’s pro rata share of partnership
liabilities. A partner’s adjusted basis in the partnership can never be less than zero.
Losses in excess of basis will be allowed when the partner’s basis is
increased above zero.
Related Parties: Loss Disallowed
—Loss: Loss
is not recognized on the sale or exchange of partnership property in a
transaction involving related parties. The rules apply to sales between:
1) A partnership and an individual partner
who owns, directly or indirectly, more than 50% interest in capital or
profits of the partnership, or
2) In the case of a transaction between two
partnerships, the same person owns, directly or indirectly, more than 50%
interest in capital or profits in each partnership.
If the purchaser later sells the property,
gain is taxable only to the extent that the gain exceeds the previously
disallowed loss.
Note: These
rules do not apply to sales or exchanges of partnership interests.
—Gain: Gain
resulting from transactions between related parties is treated as ordinary
income, unless the property in the hands of the transferee immediately
after the transfer is a capital asset. See IRS Publication 541 for more
information.
IRS Revenue Ruling 96-10, Basis
Adjustments: When a loss is disallowed on sale of property between two
related partnerships, the partners of the selling partnership reduce their
basis in the partnership (but not below zero) by their proportional share
of disallowed loss. If the purchasing partnership later sells the property
to an unrelated party, the partners of that partnership increase their basis by their share of the gain not recognized because of the previously
disallowed loss.
