TCP CPA Exam: How to Calculate Changes in a Partner’s Basis for Tax Purposes from Nonliquidating Distributions of Noncash Property

Introduction

Purpose of the Article

In this article, we’ll cover how to calculate changes in a partner’s basis for tax purposes from nonliquidating distributions of noncash property. Understanding how nonliquidating distributions of noncash property affect a partner’s basis is a key concept in partnership taxation. For tax professionals, especially those preparing for the TCP CPA exam, mastering this subject is essential for navigating complex partnership tax rules. Nonliquidating distributions, which occur when a partnership distributes property to a partner without terminating their interest in the partnership, can significantly impact the partner’s outside basis in the partnership. Accurately calculating these basis changes is vital to ensuring compliance with tax laws and avoiding misreporting income or loss.

This article will explain how noncash property distributions alter a partner’s basis, outline the relevant tax laws, and provide examples to illustrate the calculations. By understanding these concepts, you will be better equipped to handle the intricate tax treatments required for these types of transactions.

Overview

A nonliquidating distribution is a distribution made by a partnership to a partner that does not result in the termination of the partner’s interest in the partnership. These distributions may involve cash, property, or both, but the focus here will be on noncash property. Common examples of noncash property include real estate, inventory, or equipment.

The key difference between nonliquidating and liquidating distributions lies in the partner’s interest in the partnership after the distribution. In a nonliquidating distribution, the partner remains a partner and retains an ownership interest in the partnership. In contrast, a liquidating distribution completely terminates the partner’s interest in the partnership.

When a partner receives a nonliquidating distribution of noncash property, the transaction typically does not result in immediate recognition of gain or loss. However, the distribution directly affects the partner’s outside basis in the partnership. It is essential to adjust the partner’s basis appropriately, as this basis will influence future gain or loss recognition on distributions, sales of the partnership interest, or liquidating events.

Importance for TCP CPA Candidates

For TCP CPA candidates, understanding how nonliquidating distributions impact a partner’s basis is critical. This topic appears in both practical tax work and on the exam, as it forms a fundamental part of partnership taxation.

The ability to calculate the changes in a partner’s basis accurately ensures that taxable income, losses, and other tax consequences are properly reported. In practice, errors in basis calculation can result in the underpayment or overpayment of taxes, which can lead to penalties or missed tax-saving opportunities. Furthermore, since noncash property distributions can involve different types of assets, each with its own tax treatment, candidates must be prepared to navigate various scenarios.

Mastering this subject will not only help in passing the TCP CPA exam but will also build a strong foundation for real-world tax practice, where nonliquidating distributions of property are a common occurrence in partnerships.

Basic Concepts

Partner’s Basis

A partner’s basis in a partnership represents the partner’s investment or ownership stake in the partnership for tax purposes. This basis determines how much of the partnership’s income, losses, and distributions the partner must report on their individual tax return. A partner’s initial basis is generally the amount of cash and the fair market value of any property they contribute to the partnership. This basis is adjusted over time for the following:

• Increases due to the partner’s share of partnership income, additional contributions, or assumption of partnership liabilities.
• Decreases due to distributions from the partnership, the partner’s share of losses, or the reduction in partnership liabilities.

The outside basis refers to the partner’s basis in their partnership interest, while the inside basis refers to the partnership’s basis in its assets. Understanding the changes to a partner’s outside basis is essential when calculating the tax consequences of distributions, sales of the partnership interest, and other events.

Nonliquidating Distribution

A nonliquidating distribution is a distribution of cash or property made by the partnership to a partner that does not terminate the partner’s interest in the partnership. In other words, the partner continues to hold an ownership interest after the distribution. Nonliquidating distributions are a routine aspect of partnership operations and allow partners to receive returns on their investment without fully withdrawing from the partnership.

The tax treatment of nonliquidating distributions is designed to be tax-neutral in many cases, meaning that the partner typically does not recognize a gain or loss on the distribution unless certain conditions are met. However, these distributions reduce the partner’s outside basis in the partnership. If the partner’s outside basis is insufficient to cover the distribution, certain gain recognition rules may apply, and the basis cannot be reduced below zero.

Noncash Property Distributions

A noncash property distribution occurs when a partnership distributes property other than cash to a partner. Examples of noncash property include:

• Real estate: Land or buildings owned by the partnership.
• Inventory: Goods held for sale in the ordinary course of business.
• Equipment: Machinery or other assets used in the partnership’s operations.

When noncash property is distributed, the partnership’s inside basis in the property becomes the partner’s new basis in the property. However, the partner’s outside basis in the partnership is reduced by the adjusted basis of the property distributed to them. If the value of the property distributed is higher than the partner’s outside basis, the partner’s basis in the property may be limited, and gain may be recognized in some cases.

For example, if a partner receives equipment as a distribution, their basis in the equipment will be the partnership’s adjusted basis in that equipment, not its current market value. At the same time, the partner’s outside basis in the partnership is reduced by the partnership’s adjusted basis in the distributed equipment.

Tax Implications:

• No immediate gain or loss is generally recognized by the partner on the receipt of noncash property.
• The partner must adjust their outside basis in the partnership to reflect the distribution.
• The partnership’s inside basis in the distributed property transfers to the partner, impacting the tax treatment of future sales or use of the property.

Noncash property distributions require careful tracking of basis adjustments both for the partner’s outside basis and the basis of the property received. The partner’s ability to offset future gains, calculate depreciation, or determine future tax obligations will depend on these basis adjustments.

General Rule for Nonliquidating Distributions

IRC Section 731

IRC Section 731 governs the general tax treatment of nonliquidating distributions made by a partnership to a partner. Under this section, nonliquidating distributions typically do not trigger the recognition of gain or loss by the partner, with some notable exceptions. The intent behind Section 731 is to allow partners to withdraw assets from the partnership on a tax-deferred basis, as long as the partnership interest is not fully liquidated and certain conditions are met.

IRC Section 731 also provides guidelines on how partners should adjust their outside basis (the basis in their partnership interest) to reflect the distribution of cash or property. If certain conditions apply—such as receiving a distribution that exceeds the partner’s outside basis or if the property distributed has a built-in gain—Section 731 requires that the partner recognize gain.

Tax-Free Distribution Rule

The tax-free distribution rule is a key feature of nonliquidating distributions. Generally, a partner does not recognize gain or loss on the receipt of a nonliquidating distribution unless:

1. Cash Distributions Exceed Basis: If a partner receives cash that exceeds their outside basis in the partnership, the excess amount is treated as a gain and is taxable as capital gain.
2. Marketable Securities Treated as Cash: Distributions of marketable securities are treated as cash distributions, potentially leading to gain recognition if the value of the securities exceeds the partner’s outside basis.
3. Certain Depreciable Property Distributions: If certain types of property, such as unrealized receivables or inventory items, are distributed, the partner may recognize ordinary income.

In the absence of these triggering events, the partner’s receipt of noncash property generally does not result in any immediate tax consequences. The distribution reduces the partner’s outside basis, but no gain or loss is recognized at the time of the distribution.

Impact on Partner’s Outside Basis

When a partner receives a nonliquidating distribution, the partner’s outside basis in their partnership interest must be adjusted to account for the distribution. This is one of the central mechanisms for ensuring that the partner’s investment in the partnership is tracked accurately for tax purposes.

The impact on the partner’s outside basis depends on the type of distribution:

• Cash Distributions: Cash distributions reduce the partner’s outside basis dollar-for-dollar. If the distribution exceeds the partner’s basis, the excess is treated as a gain.
• Noncash Property Distributions: The partner’s outside basis is reduced by the partnership’s adjusted basis in the noncash property that is distributed. The partnership’s adjusted basis in the property, not its fair market value, is the relevant amount for adjusting the partner’s basis.

If the partner’s outside basis is reduced to zero, the partner cannot further reduce their basis. In this situation, any additional distribution (particularly cash) could result in the recognition of gain. Importantly, a partner’s basis cannot go below zero, which limits the tax-deferred nature of the distribution when the partner’s basis is fully reduced.

Ordering Rules for Distributions

The ordering rules for distributions dictate how different types of distributions (cash and noncash property) are applied to the partner’s outside basis. These rules ensure that the correct adjustments are made in a logical sequence:

1. Cash Distributions First: When a partner receives both cash and property in a nonliquidating distribution, the cash component is applied first against the partner’s outside basis. This prevents cash distributions from being sheltered by reducing basis for property distributions first, which could otherwise defer gain recognition.
2. Noncash Property Second: After the cash distribution has been accounted for, the partner’s outside basis is further reduced by the partnership’s adjusted basis in any noncash property distributed. The property’s fair market value is not considered for basis reduction purposes; only the partnership’s adjusted basis in the property is used.
3. Reduction Stops at Zero: The partner’s outside basis cannot be reduced below zero. If a distribution would otherwise result in a negative basis, gain is recognized to the extent of the excess amount, and no further reduction in basis occurs.

By following these ordering rules, partners and tax professionals can ensure that basis adjustments are applied properly, and any gain recognition is handled correctly. These rules help prevent underreporting or deferral of gain beyond what is allowed by tax law.

Adjustments to Partner’s Basis

Initial Basis Adjustments

Before a nonliquidating distribution is made, it is essential to understand how a partner’s basis is adjusted during the course of their participation in the partnership. A partner’s initial basis is generally determined by their contributions to the partnership, including cash, property, or services. However, this basis changes over time as the partner’s share of the partnership’s income, losses, and distributions fluctuate.

Here are the typical factors that adjust a partner’s basis before considering a nonliquidating distribution:

• Increases to Basis:
  • The partner’s share of taxable income or gain.
  • Additional cash or property contributions made by the partner to the partnership.
  • The partner’s share of any increase in partnership liabilities (considered as additional contributions).
• Decreases to Basis:
  • The partner’s share of partnership losses or deductions.
  • Distributions of cash or property from the partnership.
  • The partner’s share of any decrease in partnership liabilities.

These adjustments must be factored into the partner’s outside basis before calculating any changes from a nonliquidating distribution. The partner’s basis at this stage reflects the total investment in the partnership, adjusted for all prior income, losses, contributions, and liabilities.

Step-by-Step Basis Calculation

When a nonliquidating distribution of noncash property is made, it is crucial to follow the correct sequence of steps to determine the impact on the partner’s outside basis. This process ensures that any cash and noncash distributions are properly accounted for, and the partner’s investment in the partnership remains accurately reflected.

1. Starting Basis

The first step in calculating the changes in a partner’s basis due to a nonliquidating distribution is to identify the partner’s current outside basis in the partnership prior to the distribution. This is the adjusted basis after all prior income, losses, and liabilities have been taken into account.

For example, if a partner’s initial contribution to the partnership was $100,000, and over time the partner’s share of income, losses, and liabilities resulted in a net basis increase of $20,000, the partner’s starting basis before the distribution would be $120,000.

2. Reduction for Cash Distribution

If the distribution includes cash, this is applied first to reduce the partner’s basis. The cash distribution reduces the partner’s basis dollar-for-dollar. If the cash distribution exceeds the partner’s outside basis, the excess amount is recognized as a capital gain.

Example:
If a partner has a starting basis of $120,000 and receives a cash distribution of $30,000, the partner’s basis is reduced by $30,000, resulting in an adjusted basis of $90,000 ($120,000 – $30,000).

3. Adjustment for Noncash Property

After applying any cash distribution, the next step is to adjust the partner’s basis for the noncash property distributed. The basis reduction is based on the partnership’s adjusted basis in the property, not its fair market value (FMV). The partner’s outside basis is reduced by the partnership’s basis in the property, which then becomes the partner’s new basis in the distributed property.

Example:
Assume the same partner now receives noncash property (equipment) in the same distribution, and the partnership’s adjusted basis in the equipment is $50,000. The partner’s basis in the partnership is reduced by $50,000, resulting in an adjusted basis of $40,000 ($90,000 – $50,000). The partner now takes the $50,000 adjusted basis in the equipment.

If the partner’s outside basis is insufficient to cover the partnership’s adjusted basis in the property, the outside basis is reduced to zero, but the partner will not recognize a loss. Instead, the partner’s basis in the distributed property is limited to the partner’s remaining outside basis.

Summary of the Calculation Process:

1. Start with the partner’s adjusted outside basis before the distribution.
2. Reduce the basis by the amount of cash distributed, dollar-for-dollar.
3. Further reduce the basis by the partnership’s adjusted basis in the noncash property.
4. Ensure the partner’s basis does not drop below zero; if it would, stop at zero and adjust the property’s basis accordingly.

By following these steps, the correct adjustments are made to reflect the impact of the nonliquidating distribution, ensuring accurate reporting for tax purposes.

Impact of Basis on Distributed Property

Carryover Basis of Property

When a partnership distributes noncash property to a partner as part of a nonliquidating distribution, the partner generally takes the partnership’s adjusted basis in the property. This is referred to as the carryover basis rule. Essentially, the property does not receive a step-up to fair market value (FMV) at the time of the distribution; instead, the partner inherits the same basis that the partnership had in the property.

This carryover basis becomes crucial for the partner because it affects how the partner calculates future gain or loss on the eventual sale of the property. If the property is later sold, the partner will use the adjusted basis (carried over from the partnership) to determine the taxable gain or loss.

Example:
Assume a partner receives a piece of equipment from the partnership. The partnership’s adjusted basis in the equipment is $50,000, but the equipment’s FMV is $80,000 at the time of distribution. The partner’s basis in the equipment is $50,000 (the carryover basis), not $80,000. When the partner later sells the equipment, the difference between the sale price and the $50,000 basis will determine the partner’s gain or loss.

Limits on Basis Reduction

One critical rule regarding nonliquidating distributions is that a partner’s outside basis cannot be reduced below zero. This rule prevents the partner from recognizing a tax loss solely based on a distribution, even if the value of the property distributed exceeds the partner’s basis in the partnership.

If a partner’s outside basis is fully reduced to zero by the distribution, no further reduction is allowed. At this point, the partner has no remaining basis in their partnership interest to absorb additional reductions. However, the carryover basis rule still applies, and the partner will take the partnership’s basis in the property. In essence, the distribution does not create a loss or further decrease the partner’s basis beyond zero.

Example:
Assume a partner has an outside basis of $30,000 and receives a noncash distribution with an adjusted basis of $40,000. The partner’s basis in the partnership is reduced to zero, but no further reduction is possible. The partner does not recognize a loss from the excess $10,000 in property basis. However, the partner’s basis in the distributed property will be limited to $30,000—the remaining outside basis.

Unrecognized Gain

In situations where the fair market value (FMV) of the noncash property distributed exceeds the partner’s outside basis, no immediate gain is recognized by the partner, assuming certain exceptions (like cash distributions exceeding basis) do not apply. Instead, the partner takes the partnership’s adjusted basis in the property, even if the FMV is significantly higher.

The excess value of the property above the partner’s basis is considered unrecognized gain, meaning that the partner defers the gain until a later taxable event, such as selling the property. This allows the partner to avoid current taxation on the built-in appreciation of the property, deferring it until the property is sold or otherwise disposed of.

Example:
If a partner with a basis of $50,000 in their partnership interest receives a noncash property distribution with a partnership-adjusted basis of $50,000 but an FMV of $80,000, the partner’s outside basis is reduced by $50,000. The partner does not recognize a gain, even though the property is worth more than their partnership basis. The potential gain is deferred until the partner disposes of the property, at which point the gain would be recognized.

The carryover basis ensures that the partner does not step up the property’s basis to its current market value, preserving the deferral of gain until a later transaction, while the limit on basis reduction prevents losses beyond the partner’s investment in the partnership.

Special Considerations

Disproportionate Distributions

Disproportionate distributions occur when a partner receives a distribution of property that is not proportionate to their ownership interest in the partnership. This is particularly significant when the distributed property has appreciated in value. Disproportionate distributions can lead to the recognition of gain if the partner’s share of the property exceeds what they would have been entitled to receive based on their ownership percentage.

When a partner receives an appreciated property distribution disproportionately, the following tax consequences may arise:

• Recognition of Gain: If the distribution results in a shift of appreciated property to the partner, the IRS may require the partner to recognize taxable gain. This gain is recognized to prevent the partner from receiving an excessive share of the partnership’s appreciated assets without being taxed on the appreciation.
• Impact on Basis: In a disproportionate distribution, the partner’s outside basis is adjusted based on the partnership’s adjusted basis in the distributed property, but the recognized gain is included in the partner’s taxable income for that year.

Disproportionate distributions are often scrutinized to prevent tax avoidance strategies that allow certain partners to receive a larger share of appreciated property without realizing the inherent gain.

Partner’s Assumption of Partnership Liabilities

When a partner assumes a portion of the partnership’s liabilities as part of a distribution, this can have a significant effect on both the partner’s basis and the tax consequences of the distribution. According to tax rules, a partner’s assumption of partnership liabilities is treated as if the partner made a contribution of cash to the partnership, which increases the partner’s outside basis. The partnership, in turn, is treated as if it made a distribution of cash to the other partners whose share of liabilities has decreased.

The key impacts of a partner assuming a share of partnership debt are:

• Increase in Partner’s Basis: When a partner assumes a portion of the partnership’s liabilities, their outside basis increases by the amount of debt assumed. This can potentially mitigate the reduction in basis caused by other distributions.
• Potential Gain Recognition: If the partner assumes a large portion of the partnership’s liabilities as part of the distribution, and the liabilities exceed the partner’s basis, the partner may have to recognize a gain to the extent of the excess.

Example:
If a partner has a basis of $50,000 and assumes $30,000 of the partnership’s liabilities in a distribution, their outside basis increases by $30,000, resulting in a new basis of $80,000. This increased basis may offset a portion of the reduction due to a distribution of cash or noncash property, preventing the recognition of a gain.

Built-in Gain Property

When a partnership distributes property that has built-in gain—meaning its fair market value (FMV) is higher than the partnership’s adjusted basis in the property—the tax implications can be complex. The partner who receives the property does not immediately recognize the built-in gain, but they inherit the property’s carryover basis from the partnership. This can create a deferred tax liability for the partner.

Here’s how distributions of built-in gain property affect the tax calculations:

• No Immediate Gain Recognition: Generally, the partner does not recognize the built-in gain at the time of the nonliquidating distribution. The partner inherits the partnership’s adjusted basis in the property, even though its FMV may be much higher.
• Deferred Gain on Future Sale: The built-in gain remains unrecognized until the partner eventually sells or disposes of the property. At that point, the difference between the sales price and the inherited basis will be realized as a taxable gain.
• Limitations on Loss Recognition: The partner’s outside basis is reduced by the partnership’s adjusted basis in the built-in gain property. However, the outside basis cannot be reduced below zero, limiting the partner’s ability to recognize any losses associated with the distribution.

Example:
If a partnership distributes a piece of real estate with an adjusted basis of $100,000 but a FMV of $150,000, the partner who receives the distribution will take a basis of $100,000 in the property. The built-in gain of $50,000 is deferred until the partner sells the property. When the partner sells the property for $150,000, they will recognize the $50,000 built-in gain at that time, despite the original distribution being tax-deferred.

These special considerations ensure that the tax consequences of disproportionate distributions, the assumption of liabilities, and built-in gain property are handled correctly and that the appropriate amount of gain or loss is recognized at the correct time.

Examples

Example 1: Basic Example of a Partner Receiving a Distribution of Noncash Property

Let’s walk through a basic example where a partner receives a distribution of noncash property, such as equipment, from the partnership.

Scenario:
Partner A has an outside basis of $60,000 in the partnership. The partnership distributes a piece of equipment to Partner A, and the partnership’s adjusted basis in the equipment is $40,000, while the fair market value (FMV) of the equipment is $55,000.

Step-by-Step Calculation:

1. Starting Basis: Partner A’s starting outside basis is $60,000.
2. Noncash Property Distribution: The partnership distributes equipment with an adjusted basis of $40,000. Partner A’s outside basis is reduced by the partnership’s adjusted basis in the equipment.
   • Partner A’s new outside basis = $60,000 – $40,000 = $20,000.
3. Carryover Basis: Partner A now takes the equipment with a carryover basis of $40,000, which is the partnership’s basis in the equipment.

Result:

• Partner A’s adjusted outside basis in the partnership is now $20,000.
• The equipment has a basis of $40,000 for Partner A, even though the FMV of the equipment is $55,000. No gain or loss is recognized at the time of the distribution.

Example 2: Partner Receives Both Cash and Noncash Property

In this example, we’ll look at a more complex scenario where a partner receives both cash and noncash property in a nonliquidating distribution.

Scenario:
Partner B has an outside basis of $80,000. The partnership distributes $30,000 in cash and a piece of equipment with an adjusted basis of $40,000 (FMV is $60,000) to Partner B.

Step-by-Step Calculation:

1. Starting Basis: Partner B’s starting outside basis is $80,000.
2. Cash Distribution: The cash distribution of $30,000 is applied first, reducing Partner B’s outside basis dollar-for-dollar.
   • Partner B’s new outside basis = $80,000 – $30,000 = $50,000.
3. Noncash Property Distribution: The partnership distributes equipment with an adjusted basis of $40,000. Partner B’s outside basis is reduced by the partnership’s adjusted basis in the equipment.
   • Partner B’s new outside basis = $50,000 – $40,000 = $10,000.
4. Carryover Basis: Partner B takes the equipment with the partnership’s adjusted basis of $40,000. The FMV of the equipment ($60,000) does not affect the calculation at the time of distribution.

Result:

• Partner B’s outside basis in the partnership is now $10,000.
• Partner B takes the equipment with a carryover basis of $40,000.
• No gain or loss is recognized on the distribution, but Partner B’s basis has been significantly reduced due to both cash and property distributions.

Example 3: Distribution of Property with Built-in Gain

In this example, we’ll look at what happens when a partner receives a distribution of property with built-in gain, meaning the property’s FMV exceeds the partnership’s adjusted basis in the property.

Scenario:
Partner C has an outside basis of $50,000 in the partnership. The partnership distributes real estate with an adjusted basis of $30,000 and a FMV of $70,000 to Partner C.

Step-by-Step Calculation:

1. Starting Basis: Partner C’s starting outside basis is $50,000.
2. Noncash Property Distribution: The partnership distributes real estate with an adjusted basis of $30,000. Partner C’s outside basis is reduced by the partnership’s adjusted basis in the real estate.
   • Partner C’s new outside basis = $50,000 – $30,000 = $20,000.
3. Built-in Gain: Although the FMV of the real estate is $70,000, Partner C does not recognize the built-in gain at the time of distribution. Partner C takes a carryover basis of $30,000 in the real estate (the partnership’s adjusted basis).
4. Deferred Gain: The built-in gain of $40,000 (FMV of $70,000 – basis of $30,000) is deferred until Partner C sells the real estate. When sold, Partner C will recognize the deferred gain at that time.

Result:

• Partner C’s outside basis in the partnership is now $20,000.
• Partner C takes the real estate with a basis of $30,000, even though its FMV is $70,000.
• The built-in gain of $40,000 is not taxed until Partner C sells the real estate, deferring the tax liability to a future event.

These examples illustrate how nonliquidating distributions affect a partner’s basis, the potential tax implications, and the importance of tracking both the partner’s outside basis and the carryover basis of distributed property.

Reporting and Documentation

Schedule K-1

Nonliquidating distributions of cash or noncash property must be reported on the partner’s Schedule K-1 (Form 1065). This form is used to communicate a partner’s share of the partnership’s income, deductions, credits, and distributions. For nonliquidating distributions, the distributions section of Schedule K-1 is particularly important.

• Line 19 on Schedule K-1 is where distributions are reported. This includes both cash distributions and property distributions (other than cash).
• Line 19A reflects the total cash and marketable securities distributed to the partner.
• Line 19B reports the FMV of any other property distributed (i.e., noncash property).

These entries on Schedule K-1 are used to track how the partner’s outside basis is affected by the distributions and whether any gain needs to be recognized. While the FMV of noncash property is reported, the partner generally receives a carryover basis (the partnership’s adjusted basis in the property), as described earlier.

Partner’s Capital Account vs. Basis

It is important to distinguish between a partner’s capital account and their outside basis, as these two figures often differ and serve different purposes for tax reporting.

• Partner’s Capital Account: This represents the partner’s equity investment in the partnership, as reflected on the partnership’s financial statements. It is generally calculated as the partner’s initial contribution to the partnership, plus any additional contributions and share of profits, minus distributions and share of losses. The capital account is primarily an accounting measure that reflects the partner’s ownership interest in the partnership.
• Outside Basis: The outside basis represents the partner’s tax basis in their partnership interest. It is the figure used to calculate the tax implications of distributions, sales, or other taxable events. While the outside basis is affected by many of the same factors as the capital account (contributions, income, losses, and distributions), there are important differences:
  • Liabilities: The partner’s share of partnership liabilities increases the outside basis but is not reflected in the capital account.
  • Distributions: Distributions reduce both the capital account and outside basis, but the reduction in the outside basis may differ depending on whether the distribution is cash or noncash property.

Because of these differences, a partner’s capital account and outside basis will not always match. Tax professionals must pay close attention to the outside basis to ensure proper reporting of taxable events, even if the capital account reflects a different value.

Required Tax Filings

In addition to reporting nonliquidating distributions on Schedule K-1, certain other forms or disclosures may be required depending on the nature of the distribution:

• Form 4797 (Sales of Business Property): If the noncash property distributed is later sold by the partner, the partner may need to report the sale of that property on Form 4797. This form is used to report the sale of property used in a trade or business, as well as gains from involuntary conversions.
• Form 8949 (Sales and Other Dispositions of Capital Assets): If the partner sells distributed property that qualifies as a capital asset, the sale must be reported on Form 8949, which is then summarized on Schedule D. This is typically required for assets like real estate or equipment if sold by the partner.
• Form 6252 (Installment Sale Income): If the distribution involves an installment sale, where the partnership distributes property to a partner in exchange for payments over time, Form 6252 may be required to report the gain on the installment basis.
• Section 704(c) Disclosures: If the partnership distributed property that had a built-in gain (FMV exceeds the partnership’s adjusted basis), special disclosure rules under Section 704(c) may apply to ensure that the tax consequences of the built-in gain are properly tracked between the partners.

Accurate reporting on Schedule K-1 is essential to document distributions, and careful attention must be paid to the differences between the partner’s capital account and outside basis. Additionally, other tax filings may be necessary when the partner later sells the distributed property or when specific gain recognition rules apply.

Reporting and Documentation

Schedule K-1

Nonliquidating distributions of cash or noncash property are reported to the partner on Schedule K-1 (Form 1065), which outlines the partner’s share of income, deductions, credits, and distributions from the partnership. Specific lines of Schedule K-1 are used to capture the details of these distributions:

• Line 19: Reports the total distributions received by the partner during the tax year.
  • Line 19A: Records cash and marketable securities distributed to the partner.
  • Line 19B: Shows the fair market value (FMV) of noncash property (other than marketable securities) distributed to the partner.

These entries reflect the distributions made and serve as a reference for the partner to adjust their outside basis in the partnership. The reported amounts are not necessarily taxable to the partner, as the taxability of the distribution depends on the partner’s basis in the partnership, which must be tracked separately.

Partner’s Capital Account vs. Basis

A key distinction in partnership accounting is the difference between the partner’s capital account and their outside basis. These two figures serve different purposes and are adjusted by different factors:

• Capital Account: Reflects the partner’s equity in the partnership as shown on the partnership’s financial records. It is primarily used for internal accounting purposes and tracks the partner’s contributions, withdrawals, and share of profits and losses. The capital account is adjusted by:
  • Initial contributions (cash or property).
  • Allocated share of profits or losses.
  • Distributions received (cash or property).
  • Withdrawals or additional contributions.
• Outside Basis: Represents the partner’s tax basis in their partnership interest, which is crucial for determining the tax consequences of distributions, sales, or other taxable events. Outside basis is adjusted by:
  • Contributions of cash or property.
  • Allocated share of taxable income or loss.
  • The partner’s share of partnership liabilities (increases outside basis but not the capital account).
  • Distributions (cash or property).
  • Debt reductions or debt assumed by the partnership on behalf of the partner.

While both the capital account and outside basis are affected by similar items (contributions, income, losses, and distributions), the outside basis is a tax concept that includes additional considerations such as liabilities and special tax allocations. Importantly, distributions reduce both the capital account and outside basis, but the specific amount of reduction and how gains are recognized depend on the partner’s outside basis, not their capital account.

Required Tax Filings

In addition to Schedule K-1, other tax forms and disclosures may be required, depending on the nature of the distribution and the subsequent transactions involving the distributed property:

• Form 4797 (Sales of Business Property): If the distributed property is later sold by the partner and qualifies as business property, the gain or loss from the sale is reported on Form 4797. This form is used for assets such as real estate, machinery, and other depreciable property.
• Form 8949 (Sales and Other Dispositions of Capital Assets): For distributed property that qualifies as a capital asset, such as stock or investment real estate, the sale of the property must be reported on Form 8949. This form reports the details of the sale (such as acquisition and sale dates, FMV, and sales price) and summarizes gains and losses on Schedule D.
• Form 6252 (Installment Sale Income): If the distribution involves an installment sale where the partner is to receive payments over time, Form 6252 may be necessary to report the gain on the installment basis.
• Section 704(c) Disclosures: When a partnership distributes property that has a built-in gain (i.e., FMV exceeds the partnership’s adjusted basis), special rules under Section 704(c) require the partnership to disclose and allocate the tax consequences of the built-in gain to the appropriate partners.

These additional forms ensure that tax is correctly reported on future transactions involving the distributed property, particularly in cases where the property is sold or the partner recognizes gain from the distribution. Proper reporting and documentation ensure that both the partnership and partner comply with IRS rules regarding distributions and the associated tax consequences.

Conclusion

Recap of Key Points

Nonliquidating distributions of noncash property have important implications for a partner’s basis in the partnership. The key takeaways include:

• Nonliquidating distributions allow a partner to receive property or cash from the partnership without fully terminating their interest. These distributions generally do not result in immediate gain or loss recognition unless specific conditions apply, such as when cash distributions exceed the partner’s outside basis.
• A partner’s outside basis in the partnership is reduced by the adjusted basis of the property distributed to them, and the property’s carryover basis (the partnership’s adjusted basis) becomes the partner’s new basis in the distributed property.
• It’s crucial that a partner’s outside basis is never reduced below zero, as this could result in the recognition of gain if distributions exceed the partner’s basis.
• Built-in gain property (property with a fair market value higher than its adjusted basis) allows for the deferral of gain until the partner disposes of the property. However, no immediate tax is triggered upon distribution unless specific conditions are met.
• Proper documentation, including Schedule K-1, and understanding the differences between a partner’s capital account and outside basis are essential for accurate tax reporting and basis calculation.

Study Tips for TCP CPA Candidates

When preparing for the TCP CPA exam, it’s critical to thoroughly understand the rules governing nonliquidating distributions and their impact on a partner’s basis. Here are some final tips to help with exam preparation:

• Know the Basis Adjustments: Be sure to understand the factors that increase or decrease a partner’s outside basis, including income, losses, contributions, distributions, and liabilities. This knowledge is fundamental to correctly calculating the partner’s basis both before and after a distribution.
• Master the Ordering Rules: Always remember the proper ordering when reducing a partner’s basis for distributions. Cash is applied first, followed by noncash property. Understanding this sequence will help avoid common errors.
• Watch for Gain Triggers: Be aware of situations where a gain must be recognized, such as when cash distributions exceed the partner’s basis or when disproportionate distributions occur. Ensure that you can identify these scenarios and understand how the gain is calculated.
• Understand Carryover Basis: When property is distributed, remember that the partner takes the partnership’s adjusted basis in the property, not its fair market value. This carryover basis will affect future tax calculations if the partner sells the property.
• Practice with Examples: Work through multiple practice problems involving both simple and complex distributions. Focus on scenarios where cash and noncash property are distributed together, as these are more likely to appear in exam questions and can be tricky to calculate.

By mastering these concepts and avoiding common pitfalls in basis calculations, TCP CPA candidates will be well-prepared to tackle questions related to nonliquidating distributions on the exam.