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When a business operates as a partnership, the partners each report a percentage -- which is usually the same as their percentage of ownership -- of annual earnings on their personal returns. As a result, the tax effects of a partnership that makes liquidating distributions only impacts the partners who receive them. To be taxed as a liquidating distribution, however, a partner's interest in the partnership must terminate.
Only partners who receive a liquidating distribution of cash may have an immediate taxable gain or loss to report. The value of marketable securities, such as stock investments that are traded on a public stock exchange, and decreases to your share of the partnership's debt are both treated as cash distributions. When the total amount of cash distributed is more than a partner's basis in her partnership interest, the difference in the two amounts is a gain. A loss results when the liquidating distribution is less than the partner's basis in the partnership. Partners, however, can only take a loss on their returns if it's solely the result of a liquidating distribution of cash, outstanding partnership receivables or inventory items.
If the partnership distributes property -- anything other than cash and property treated as cash -- during its liquidation, it has no immediate tax effect. Instead, gain or loss is delayed until you sell the property. Provided the liquidation terminates your entire interest in the partnership, your tax basis in the distributed property is equal to your adjusted basis in the partnership interest minus the cash distributed to you. Regardless of the amount of cash you receive, your basis in the distributed property is never less than zero. If your basis is zero, this means the amount you eventually sell the property for is all taxable gain.
Before you can figure out the tax effects of the liquidation, you'll need to know your adjusted tax basis in the partnership. Initially, your basis is equal to the amount of cash plus your basis -- or cost -- in any property contributed to the business. Your basis increases and decreases over the years for required adjustments to arrive at adjusted basis -- the amount you'll use to calculate gain or loss after the liquidation. For example, increasing adjustments are made for additional contributions you make and to reflect your share of partnership income, whereas decreasing adjustments are required for partnership losses and profit withdrawals.
Upon liquidation of a partnership, the Internal Revenue Service views the distributions as a sale of a partnership interest; as a result, gains are generally taxed as long-term capital gains to partners. Therefore, partners who have held an interest in the partnership for more than one year as of the date of a liquidating distribution will pay lower rates of tax on the gain than they do on a partnership's operating profit.
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