Avoiding tax on liquidating distributions of partnership property through timing of distributions.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 17th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Ft. Worth, TX, 2003 ([phone]; www.ppcnet.com).

Facts: Mary and Michelle are equal partners in Ma Belle, an accrual-basis general partnership. Early in 2003, they decided to liquidate the partnership. At the beginning of 2003, Ma Belle's assets were:

Adjusted
Basis     Fair market value

Cash            $ 50,000     $ 50,000
Accounts          30,000       25,000
Fixed assets      30,000      200,000

Total           $150,000     $275,000

The partners anticipate $25,000 of the receivables will be collected before the end of 2003; the balance will be uncollectible. They plan to distribute all the fixed assets in kind as soon as possible. (None of the partnership's noncash assets were contributed by partners, and the fixed assets have no recapture potential.) However, for ease of collection, the partners do not wish to distribute the accounts receivable. They expect the partnership will break even for the portion of 2003 it remains in existence. Each partner has a $75,000 basis in her partnership interest. Issue: How should the partnership's assets be distributed to avoid or minimize tax to the partners?

Analysis

A tax adviser should consider two factors in minimizing or eliminating tax on liquidating distributions to the partners:

1. The timing or ordering of the distributions (i.e., whether to distribute cash or property first).

2. Each partner's individual tax situation.

The ordering of distributions is important; a cash distribution produces gain recognition to the extent it exceeds a partner's basis in his or her partnership interest, according to Sec. 731(a)(1) and Regs. Sec. 1731-1(a)(1). However, a proportionate distribution of property (other than cash or marketable securities treated as money) does not produce taxable income to the recipient, regardless of the basis of the partner's partnership interest. Accordingly, the tax adviser should advise the partners not to distribute the property before the cash. If they do, the property will soak up basis, increasing the likelihood a cash distribution Mil be taxable. If the cash distribution precedes the property distribution or accompanies it as part of the same transaction, the cash will soak up the basis, reducing the potential for gain recognition on the distribution; see Sec. 732(a)(2) and Regs. Sec. 1.732-1(a).

The choice of property to distribute to each partner is also an important decision in a liquidation; also, nontax factors cannot be overlooked. However, if each partner's basis is not proportionate to his or her interest and all other things are equal, the tax adviser might suggest limiting the cash distributed to partners with a lower basis (because a distribution of cash in excess of a partner's basis is taxable), to help minimize the current tax resulting from the distribution. However, to keep the distributions in line with the partners' sharing ratios, such disproportionate cash distributions will also result in disproportionate property distributions.

Because this planning alternative results in disproportionate property distributions, it may not be viable if (unlike in this situation) the partnership's assets include significant unrealized receivables, appreciated inventory and recapture assets ("hot assets"). When planning for the distribution of these assets, the tax adviser must consider the collapsible partnership rules.

An additional point is the depreciation deductions to be taken after the distribution. To the extent the transferee's basis in the property does not exceed that of the partnership, the partner continues the partnership's method and life (i.e., steps into the partnership's shoes). To the extent there is a basis step-up, it is deemed a new acquisition placed in service on the distribution date.

Conclusion

Because Mary's and Michelle's basis in their respective partnership interests are equal, the tax adviser has no reason to suggest distributing certain assets to either partner; nontax considerations should rule.

If a series of liquidating distributions will be made, it is essential for the adviser to tell the partners to distribute the $50,000 cash first, to avoid gain recognition. As the receivables ate collected, the cash proceeds should be distributed as soon as possible while the partners have basis to offset the cash distributed. The fixed assets should be distributed last, preferably after all the cash has been distributed (including the proceeds from the collection of receivables). The property distribution will not trigger gain until the property is sold>> or disposed of by the partners in a taxable transaction.

Similarly, if the partners want to dissolve the partnership before the accrual-basis receivables have been collected, the receivables should not be distributed until all the cash has been distributed. Any remaining accrual-basis receivables could then be distributed along with the fixed assets, without triggering gain recognition. (The partnership is on the accrual basis. The income from the receivables has already been recognized; thus, the receivables ate not "unrealized" receivables under Sec. 751.)

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Potomac, MD