The Implications of Debt-Financed Distributions (article)
These days, entities classified as partnerships for income tax purposes often hear the calling from partners to monetize a portion of the value the enterprise owns, even though those partners are not yet ready to sell their partnership interests. One way partnerships can accomplish this is by entertaining a debt-financed distribution to these partners. Cash can be supplied in a tax-free (or, to be more precise, tax-deferred) manner by a lender and ultimately to these partners, but partners need to understand the consequences when the partnership interest is eventually sold.
All partnership distributions to partners are treated as current distributions, except for those that are made to liquidate entirely the distributee’s partnership interest. Current distributions generally result in recognized gain to the distributee partner only when the money distributed exceeds the adjusted basis of the distributee’s partnership interest. The following example demonstrates these principles:
Reggie’s Diner, LLC (“Diner”) is owned 1/3-each by partners George, Jerry, and Cosmo. Diner originally was formed by contributions of $100,000 cash from each partner. The partners’ capital and profits interests in Diner are pro rata. After several years of break-even operations, each partner’s tax basis in his partnership interest is $100,000, and the fair value of each partner’s interest is $250,000. George then receives $125,000 cash to reduce his stake in Diner by half (from 1/3 to 1/6). George recognizes a capital gain of $25,000 on his receipt of this cash, which is treated as a current distribution.
The tax basis of one’s partnership interest is the key determinant of whether gain recognition is appropriate upon receipt of current cash distributions, as can be seen in the above example. A partner’s tax basis in his partnership interest initially is established by the amount of money and the adjusted basis of property contributed by him to the partnership, or by his cost of such interest if acquired from another partner. Current distributions of money decrease the tax basis of a partnership interest (but not below zero). As illustrated in the previous example, gain must be recognized for excess distributions since the gain embedded in the partner’s partnership interest cannot be preserved in the distributed cash.
A partner’s basis in his partnership interest also includes any increase in a partner’s share of the liabilities of a partnership, or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities. This is because each is considered a contribution of money by such partner to the partnership.
The manner in which partners are considered to “share” in the liabilities of the partnership is an important factor in the determination of each partner’s adjusted basis in his partnership interest. Indeed, the liability sharing rules permit partners to receive distributions of proceeds of partnership liabilities without recognizing gain. A continuation of the previous example demonstrates this concept:
Diner allocates profits 1/6 to George, 5/12 to Jerry, and 5/12 to Cosmo after the previous transaction. The partners’ tax bases in their partnership interests are $0, $100,000, and $100,000; respectively. In an effort to monetize most of the remaining fair value of Diner without liquidating any partner’s interest, Diner borrows $600,000 from Acme Bank (secured by Diner’s sole intangible asset, a soup recipe). Assume that no partner or related person bears the economic risk of loss for this loan and that the partners’ shares of this partnership liability are $100,000, $250,000, and $250,000; respectively. Diner immediately distributes the loan proceeds to its partners, with $100,000 distributed to George, $250,000 distributed to Jerry, and $250,000 distributed to Cosmo. Diner has no property to which §751 applies, no other debt, and its only assets are $175,000 of security deposits. After the distribution, the partners’ profits interests in Reggie’s Diner remain at 1/6, 5/12, and 5/12; respectively. As measured just prior to the distribution (but after the borrowing), each partner’s tax basis in his partnership interest is adjusted to $100,000, $350,000, and $350,000; respectively. The distribution proceeds then reduce each partner’s tax basis in his partnership interest to $0, $100,000, and $100,000; respectively.
As previously noted, the tax-free distribution here is more aptly described as tax-deferred. Any decrease in a partner’s share of the liabilities of the partnership, or any decrease in a partner’s individual liabilities by reason of the assumption by the partnership of such individual liabilities, is considered a distribution of money to the partner by the partnership. This deemed distribution of money therefore provides a decrease to the tax basis of a partner’s partnership interest, or if the deemed distribution exceeds the partner’s basis, the partner recognizes income. Likewise, the amount realized by a partner on the disposition of a partnership interest includes the reduction in the selling partner’s share of liabilities.
In the simplest demonstration of this tax-deferred concept, if any one of the partners in the previous example were to sell his entire partnership interest for $0 cash, the amount realized would include the seller’s previous share of partnership debt. As in the previous example, the partners’ share of this partnership liability was $100,000, $250,000, and $250,000; and the tax basis in each partners’ partnership interest was $0, $100,000, and $100,000; respectively. Hence, any one of the partners stands to recognize gain equal to $100,000, $150,000, or $150,000; respectively.
This final example was kept simple to clearly demonstrate that the same gain results at the final sale transaction that would have resulted (i.e., cash distribution in excess of basis) without the original inclusion of nonrecourse debt in the tax basis of each partner’s partnership interest. Hence, the gain effectively is deferred to the later year of the sale transaction. This provides for a highly desirable result in the year of the debt-financed distribution, but partners may lose sight of the “end game” here, particularly when many years separate the original distribution from the “end game”. Consult your local CBIZ MHM tax advisor to discuss the implications of making debt financed distributions.
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