The federal tax deadline was April 15 for most filers — and if you missed it, you should file your return and pay your balance as soon as possible, experts say.
You and one or more other individual co-owners operate a business or investment activity as a partnership and now intend to shut it down.
You won’t be surprised to hear that there will be federal income tax implications.
This article summarizes the tax implications in what we think are probably the three most common partnership shutdown scenarios.
Scenario 1. One partner buys out the other partner(s) for cash and continues to operate the business or investment activity.
Scenario 2. You and the other partners decide to liquidate the partnership by selling all of its assets for cash and distributing the cash to the partners.
Scenario 3. You and the other partners decide to liquidate the partnership by distributing all of the partnership’s existing assets to the partners.
Key point. To keep the length of this analysis manageable, we will make the simplifying assumption that you and the other partners are all individuals.
Key point. Understand that the same federal income tax results that we explain here will also apply if you operate your business or investment activity as a multi-member LLC that’s classified as a partnership for federal income tax purposes, and where all the LLC members are individuals. If that’s your deal, substitute LLC for partnership and LLC member for partner as you read this.
With those thoughts in mind, let’s get started.
Scenario 1: One Partner Buys Out the Other Partner or Partners for Cash (aka Partnership Divorce).
Since only one owner remains in this scenario, a partnership no longer exists. This scenario usually, but not always, arises with two-person partnerships.
The exiting partner will have a taxable gain or loss from selling his or her partnership interests.
As a general rule, the gain from selling a partnership interest is treated as a capital gain. The lower long-term capital gains tax rates apply if the partnership interest has been owned for more than one year.
But you can have some higher-taxed ordinary income from selling your partnership interest if the partnership has certain assets such as zero-basis receivables, appreciated inventory, and depreciable or amortizable assets that are worth more than their depreciated tax basis. Therefore, some part of the gain from selling a partnership interest can be higher-taxed ordinary income rather than lower-taxed long-term capital gain.
If you are only a passive investor in the partnership, you may owe the 3.8 percent net investment income tax (NIIT) on all or part of the gain from selling your partnership interest.
Finally, you may also owe state income tax on the gain from selling your partnership interest.
Two-Person Partnership.
If you buy out the other partner in a two-person partnership for cash, the selling partner will have a taxable gain or loss from selling the partnership interest, as explained above. Here’s the rest of the drill in this situation.
1-1. The partnership is then deemed to make a liquidating distribution of all of its assets to the two partners.
1-2. You as the purchasing partner are deemed to acquire the assets that were deemed to have been distributed to the selling partner. Your combined tax basis in those assets equals what you paid to acquire the selling partner’s interest. Your holding period for those assets starts on the day after the purchase.
1-3. Next, you are deemed to receive a distribution of your share of partnership assets from your former interest in the partnership. You must recognize a taxable gain to the extent you receive cash in excess of the tax basis of your former partnership interest immediately before the deemed distribution.
You can potentially have a taxable loss from the deemed distribution if you receive only money and unrealized receivables.
1-4. Your combined tax basis in the non-cash assets received in the deemed distribution of your share of partnership assets from your former partnership interest equals the tax basis of your interest immediately before the deemed distribution reduced by any money deemed to be distributed to you.
1-5. Your holding period for the non-cash assets received in the deemed distribution of your share of partnership assets from your former partnership interest includes the partnership’s holding period.
You can do whatever you want with the former partnership assets. You could put them into a sole proprietorship or a single member LLC that’s treated as a sole proprietorship for tax purposes, or you could put them into a C corporation, or an S corporation, or an LLC that’s treated as a C or S corporation, or whatever. Your choice.
1-6. If the selling partner has suspended passive losses from the partnership’s prior-year activities and/or a passive loss for the year of sale, the passive losses become deductible in the year in which the entire partnership interest is sold. This favorable outcome assumes that the selling partner does not have any outside interest or interests in the former partnership’s passive activity or activities.5
1-7. File a final partnership federal income tax return on IRS Form 1065 (including final partner Schedules K-1) for the year in which the partnership is shut down.
Partnership with More Than Two Partners
Basically, the same drill that we just explained applies when a partnership has more than two partners and one partner buys out the interests of all the other partners.
So, run the same drill for each of the exiting partners and the same drill for the individual who buys them out.
File a final partnership federal income tax return on IRS Form 1065 (including final partner Schedules K-1) for the year in which the partnership is shut down.
Scenario 2: Partnership Sells All Its Assets for Cash and Distributes the Cash to the Partners (Simplest Case, Complete Liquidation).
Here’s the tax drill in this scenario where the partnership sells all of its assets for cash, pays off all of its liabilities, and distributes the remaining cash to the partners in complete liquidation of the partnership.
2-1. The partnership recognizes taxable gains and/or losses from selling its assets. You will receive a Schedule K-1 from the partnership that shows your share of the passed-through gains and/or losses. Report them on your Form 1040. Ditto for the other partners.
2-2. Your share of passed-through gains from selling most business assets that have been held for more than one year will be Section 1231 gains that are generally taxed at the same rates as long-term capital gains.
2-3. Gains attributable to first-year Section 179 depreciation and first-year bonus depreciation can be taxed at higher ordinary income rates.7 Gains attributable to non-first-year real estate depreciation are so-called unrecaptured Section 1250 gains, which can be taxed at a federal rate of up to 25 percent.
2-4. If you contributed property to the partnership, and its fair market value was different from its tax basis at the time of the contribution, you may be allocated a specially calculated taxable gain or loss when the partnership sells the property.9
2-5. If you are only a passive investor in the partnership, you may owe the 3.8 percent NIIT on all or part of the passed-through gains from selling the partnership’s assets.
2-6. You may owe self-employment tax on your share of passed-through gains from selling certain partnership assets, such as receivables and inventory.
2-7. Finally, you may also owe state income tax. Ask your tax advisor for details about all these add-on taxes.
2-8. If the cash distributed to you in the liquidating distribution (including certain marketable securities that are treated as cash) exceeds the tax basis of your partnership interest immediately before the distribution, you will have a taxable capital gain equal to the difference.
2-9. If the cash distributed to you is less than the tax basis of your partnership interest immediately before the distribution, you will have a taxable capital loss equal to the difference.
2-10. However, the passed-through gains and losses from selling the partnership’s assets increased and decreased, respectively, the tax basis of your partnership interest. Therefore, the cash you receive in the liquidating distribution will most likely match the basis of your partnership interest. If so, you will have no taxable gain or loss from the distribution, and your tax results will be limited to the impact on your Form 1040 from the passed-through gains and losses from selling the partnership’s assets.
2-11. If you have suspended passive losses from the partnership’s prior-year activities and/or a passive loss for the year of sale, the passive losses become deductible in the year in which you sell your entire partnership interest. This favorable outcome assumes that you don’t have any outside interest or interests in the former partnership’s passive activity or activities. Ditto for the other partners.
2-12. File a final partnership federal income tax return on IRS Form 1065 (including final partner Schedules K-1) for the year in which the partnership is shut down.
Observation: As you can see, the tax results in this scenario are not so simple. You should hire a tax professional to help sort things out
Scenario 3: Partnership Distributes All Its Assets to the Partners (More Complicated, Complete Liquidation)
Here’s the drill in this more-complicated scenario where the partnership distributes all of its existing assets to the partners in complete liquidation of the partnership.
3-1. If cash distributed to you in the liquidating distribution (including certain marketable securities that are treated as cash) exceeds the tax basis of your partnership interest immediately before the distribution, you will have a taxable capital gain equal to the difference. If you are only a passive investor in the partnership, you may owe the 3.8 percent net investment income tax (NIIT) on all or part of the gain.17 You may also owe state income tax.
3-2. If you receive only cash, and/or unrealized receivables, and/or inventory in your liquidating distribution, you will have a taxable capital loss if the tax basis of your partnership interest immediately before the distribution exceeds the sum of the cash plus your tax basis in the distributed receivables and inventory.
3-3. If 3-1 or 3-2 apply and you have suspended passive losses from the partnership’s prior-year activities and/or a passive loss for the year of sale, the passive losses become deductible in the year in which you sell your entire partnership interest. This favorable outcome assumes that you don’t have any outside interest or interests in the former partnership’s passive activity or activities. Ditto for the other partners.
3-4. You may have to recognize some unexpected taxable gain or loss if your liquidating distribution includes a disproportionate share of the partnership’s “hot assets.” Hot assets can include receivables, certain appreciated inventory, and depreciable or amortizable assets that are worth more than their depreciated or amortized tax basis.
3-5. If none of the above circumstances apply to you or the other partners, the general rule is that the liquidating distributions will not trigger any taxable gains or losses for the partners or the partnership.
3-6. What is your tax basis in non-cash partnership assets that are distributed to you in liquidation of your partnership interest? Good question. Potentially complicated rules apply, and different rules apply in different circumstances. These rules are beyond the scope of this analysis. Ask your tax professional for the specifics—if you really want to know!
3-7. File a final partnership federal income tax return on IRS Form 1065 (including final partner Schedules K-1) for the year in which the partnership is shut down.
Takeaways.
The federal income tax consequences from shutting down a partnership can be pretty simple—as in Scenario 1; more complicated—as in Scenario 2; or darned complicated—as in Scenario 3.
We did not address the most-complicated scenario where the partnership sells some of its assets and distributes the resulting sales proceeds and its remaining assets to the partners in complete liquidation of their partnership interests.
We did not address some other complicated issues like what happens when a partnership owns installment sale receivables.
At the least, we hope this analysis gets you prepared to discuss partnership shut-down tax issues with your tax professional.
