If you’re a part of a partnership or intending to form one, you may already have wondered: how are partnership distributions taxed? It’s an important question and one that many business owners ask before forming a partnership.

Understanding how distributions work and how they affect your taxes can save you from surprises during tax season. And of course, avoid lots of stress.

In this blog, we will discuss everything in detail and in plain terms, so that all your questions regarding partnership distributions are answered in the simplest terms. No jargon, no accounting maze, just clear answers. Let’s get into it.

What Are Partnership Distributions?

Let’s start with the basics. A partnership distribution is money or property a partner receives from the partnership. These distributions usually come from the partnership profits. But it’s not always about profits, sometimes distributions also return the money a partner initially invested.

Partnership distributions are different from salaries. Partners don’t get paid salaries like regular employees in most cases, instead they receive a share of the profits (called distributive share). Partners may also get actual cash or property distributions throughout the year.

Are Partnership Distributions Taxable?

Now for the big question: Are partnership distributions taxable? The answer depends on the type of distribution and your individual tax situation.

Here’s where it gets interesting, not all distributions are automatically taxable. Some are, others aren’t. it depends on your basis in the partnership (we’ll explain that next) and the type of distribution you receive.

Understanding Basis: The Key to Taxation of Partnership Distributions

The basis is actually your investment in the partnership. It starts with how much money or property you put into the partnership and changes over time based on income, losses, and distributions.

If you receive a distribution that is less than or equal to your basis, it’s usually not taxable. That’s because the IRS sees it as you simply taking back a part of what you initially invested.

But if the distribution is more than your basis, the excess is taxable. In fact, in most cases, this will be taken as a capital gain.

Let’s break that down with an example:

• You have a basis of $50,000 in your partnership
• You receive a distribution of $70,000
• The first $50,000 is not taxable.
• The extra $20,000 is taxable and usually treated as a capital gain.

This is the foundation of how the taxation of partnership distribution works.

Types of Partnership Distributions

There are mainly two types of distributions: current distributions and liquidating distributions.

Current Distributions

These are regular partnership distributions partners receive during the life of the partnership. They can be in the form of cash, property, or even a reduction in the partner’s share of partnership liabilities.

For tax purposes, these are not usually taxable if they don’t exceed your basis. But remember, they do reduce your basis. That means if you receive another distribution later, you might have to pay taxes on it if your basis has dropped.

Liquidating Distributions

These distributions are disbursed when a partnership is winding up or a partner is leaving. These can be more complicated in terms of taxes.

• If the distribution is cash and it’s less than your basis, again, it’s not taxable.
• If it’s more, the excess is taxed.
• If you receive property instead of cash, there may be no immediate tax, but it can affect your taxes when you eventually sell the property.

In either case, the taxation of partnership distributions depends heavily on your basis and how the distribution is structured. A tax expert can better help you understand the type of distribution and its taxation.

What About Guaranteed Payments?

Sometimes, partners receive guaranteed payments, a fixed amount paid regardless of the partnership’s profits. These are not considered distributions. Instead, they’re treated like income and taxed accordingly.

So, if you’re a partner getting guaranteed payments for services or capital, expect to pay self-employment tax and report the income just like any other compensation.

How Are Non-Cash Distributions Taxed?

Cash is straightforward, but what if you receive property or assets instead?

• The partnership usually doesn’t recognize a gain or loss on the distribution.
• You, as the partner, generally don’t report a gain unless the value of the distribution exceeds your basis.
• The basis of the distributed property becomes important when you sell it later. That’s when taxes may come into play.

So, while non-cash distributions may not be taxable right away, they can affect future taxes.

What Should You Track?

To stay on top of the taxation of partnership distributions, here’s what to keep track of.

• Your beginning basis in the partnership
• Additional capital contributions
• Your share of partnership income or loss
• Distributions you receive (cash or property)
• Guaranteed payments
• Changes in liabilities you’re responsible for

A clear up-to-date capital account is your best friend when it comes to staying tax ready.

Simplify Your Taxes with Monily

Understanding how partnership distributions are taxed doesn’t have to be overwhelming. Once you get familiar with the concepts of basis, types of distributions, and what triggers taxes, the process becomes much easier.

Still have questions? Let’s help you.

At Monily, we assist business owners, partners, and entrepreneurs handle their partnership taxes with confidence. From tracking your basis to planning distributions wisely, we have got your back.

If you want to make your taxation of distribution process smoother, book a consultation with us.

Raza Agha

Raza Agha is a Senior Manager at Monily, specializing in global finance accounting and management. With a decade of experience, including roles as Accounting Manager and Assistant Manager at Health Grades Analytics, Raza drives financial efficiency and accuracy. He holds an MBA and Bachelor's degree in Accounting and Finance from The University of Texas at Austin and is a qualified ACA ICAEW and ACCA member. Based in Texas, Raza excels in strategic financial planning and operations.