Dissolving a Partnership: Tax Ramifications

When you and one or more co-owners decide to terminate a business or investment partnership, federal income tax consequences will invariably ensue.

This article elucidates the tax ramifications under what we consider to be the three most prevalent partnership dissolution scenarios.

Scenario 1: A Partner Acquires the Remaining Partner(s) for Cash and Continues the Enterprise

In this scenario, the remaining individual will continue the business, resulting in the dissolution of the partnership.

The exiting partner will experience a taxable event, realizing either a gain or a loss upon the sale of their partnership interest. Generally, the profit from selling a partnership interest is categorized as a capital gain, benefiting from lower long-term capital gains tax rates if held for over a year.

However, should the partnership possess assets such as zero-basis receivables, appreciated inventory, or depreciable/amortizable assets worth more than their tax basis, part of the gain may be taxed at higher ordinary income rates. Passive investors may also incur the 3.8% net investment income tax (NIIT) on all or part of the gain. Additionally, state income taxes may apply.

For two-person partnerships, if you buy out your partner, the partnership is deemed to liquidate its assets, distributing them to the partners. The purchasing partner acquires the assets, with their tax basis reflecting the purchase price. The holding period begins the day after acquisition. The purchasing partner also recognizes a taxable gain if cash received exceeds the tax basis of the partnership interest prior to distribution.

Suspended passive losses for the selling partner become deductible in the year of the sale, assuming no continued interest in the partnership’s passive activities. A final federal income tax return on IRS Form 1065, including partner Schedules K-1, must be filed.

For partnerships with more than two partners, the process is analogous, with each exiting partner and the acquirer undergoing the same tax procedures. The final partnership tax return on IRS Form 1065 must be filed.

Scenario 2: Partnership Liquidates by Selling All Assets for Cash

In this scenario, the partnership sells its assets, pays off liabilities, and distributes the remaining cash to partners.

The partnership recognizes taxable gains/losses from the asset sales, reported on individual Form 1040s via Schedule K-1. Gains from business assets held over a year are generally Section 1231 gains, taxed at long-term capital gains rates. Gains from first-year depreciation can be taxed at higher ordinary rates, and gains from non-first-year real estate depreciation may face up to 25% federal tax rates.

Contributors of property to the partnership may have special gain/loss allocations upon sale. Passive investors could owe the 3.8% NIIT, and some gains may be subject to self-employment tax. State income taxes might also apply.

If liquidating distribution cash exceeds the partnership interest’s tax basis, a taxable capital gain arises. Conversely, if cash is less, a capital loss ensues. The distributed cash usually matches the partnership interest’s adjusted basis after gains/losses, potentially resulting in no additional taxable events.

Suspended passive losses become deductible in the year of sale. A final federal income tax return on IRS Form 1065 must be filed.

Scenario 3: Partnership Liquidates by Distributing All Existing Assets

In this more intricate scenario, the partnership distributes its assets in liquidation.

If cash or marketable securities (treated as cash) exceed the partnership interest’s tax basis, a taxable capital gain arises, potentially incurring the 3.8% NIIT for passive investors and state income taxes. Conversely, receiving only cash, receivables, and inventory, with a basis exceeding the distribution’s sum, results in a capital loss.

Suspended passive losses become deductible in the year of sale. Unexpected gains/losses may occur if disproportionate “hot assets” (receivables, appreciated inventory, etc.) are distributed. Generally, liquidating distributions do not trigger taxable gains/losses for partners if none of these circumstances apply.

Tax basis for non-cash assets distributed can be complex, varying by circumstance. Consult a tax professional for specifics. A final federal income tax return on IRS Form 1065 must be filed.

Conclusions

Tax implications from partnership dissolution can range from simple to highly complex.

We did not cover the scenario where the partnership sells some assets and distributes proceeds and remaining assets.

We also did not address complications from installment sale receivables or other complex issues.

If you have questions or are considering dissolving your partnership, the Houston accountants at Jones CPA group are here for you. Schedule a consultation today.