What are distributions?
To begin with, distributions from both partnerships and S-corporations are the same. Distributions can consist of the following:
- Withdrawals by partners in anticipation of current year earnings
- Distribution of the current or prior year earnings not needed for working capital
- Complete or partial liquidation of a partner’s interest
- Final distribution to all partners when the company is liquidated
In the case of any of these distributions, the distribution must be reported on your tax return in the tax year it was received. However, there are certain instances where distributions may instead be treated as a sale or exchange, such as in the following situations:
- Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner’s interest in other partnership property including cash
- Other property (cash included) distributed in exchange for a partner’s interest in unrealized receivables or substantially appreciated inventory items
- A distribution of property to the partner who contributed the property to the partnership
- Payments made to a retiring partner or successor in the interest of a deceased partner that are the partner’s distributive share of partnership income or guaranteed payments
How are distributions different from guaranteed payments?
Guaranteed payments differ from distributions in that they are considered salary and “other” payments. Guaranteed payments are compensation to members of a partnership in return for their time invested, services provided, or capital made available. These payments are also taxable income and are treated as ordinary income and self-employment income for tax purposes. This means that guaranteed payments do not have to pay income and FICA taxes but will be subject to self-employment taxes and estimated income taxes as necessary. Guaranteed payments are also beneficial to the company they are paid out from, as they can be deducted as a business expense. Distributions are classified as profit-sharing payments as opposed to ordinary income but must also be reported on the receiving partner’s individual tax return. When a distribution of cash or property is realized, the partner’s adjusted basis is decreased, but it cannot decrease beyond zero. In any case, the partnership does not realize the gain or loss because of a distribution to the partners.
What is partnership basis?
The basis of a partnership is the money the partnership has plus the adjusted basis of any property contributed by the partners, including cash and noncash assets. Partnership basis is divided into two concepts, inside basis and outside basis. Inside basis is the adjusted basis of each partnership asset, according to the partnership tax account. Outside basis represents each partner’s basis in the partnership interest.
For example, if Partner A contributes an asset with a tax basis of $20,000 and a fair market value (FMV) of $50,000, while partner B contributes $50,000 cash, the total increase in inside basis of the partnership would be the combined $100,000. However, the outside basis for Partner A would be $20,000, while Partner B’s would still be $50,000. If Partner A sold their partnership interest for $50,000, they would recognize a gain of $30,000, while Partner B would recognize no gain if sold at the same price.
Do partnership distributions and guaranteed payments lower basis?
When a partnership or S-corporation distributes cash or noncash assets the partners’ basis will be decreased accordingly, as the basis is determined by cash or noncash assets contributed to the business. This also means if cash or noncash assets are contributed to the business, basis will increase. In the case of guaranteed payments to partners, basis will not be affected, as they are treated as taxable compensation to the partners.
How are distributions and guaranteed payments taxed?
A common issue that arises with distributions is the possibility of double taxation, as partners are taxed on the income of the partnership regardless of distributions. It is important to make sure that the partner is not reporting the distribution a second time. Both guaranteed payments and distributions are reported on Schedule K and K-1 on the business tax return, while partners would report the guaranteed payments on Schedule E as ordinary income on their personal tax return. Partners are taxed on the net income a partnership earns based on their partnership percentage, regardless of any distribution, unless they exceed the partner’s basis. In the case of a partnership distributing more than the partner’s basis, the difference between the partner’s basis and the distribution will be taxable income. Like a guaranteed payment the difference will be subject to self-employment tax and will require estimated income tax payments as necessary.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. You should consult with your own tax, legal, or accounting advisor before engaging in any transaction.