Example of nonliquidating distribution

A partner's income or loss from a partnership is the partner's distributive share of partnership items for the partnership's tax year that ends with or within the partner's tax year.

These items are reported to the partner on Schedule K-1 (Form 1065). When it is necessary to determine the gross income of a partner, the partner's gross income includes his or her distributive share of the partnership's gross income.

To compute the distributive share of these items, the partnership's tax year is considered ended on the date the partner disposed of the interest.

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That daily portion is then allocated to the partners in proportion to their interests in the partnership at the close of each day.

This rule applies to the following items for which the partnership uses the cash method of accounting. If a partner's entire interest in a partnership is disposed of, whether by sale, exchange, liquidation, the partner's death, or otherwise, his or her distributive share of partnership items must be included in the partner's income for the tax year in which membership in the partnership ends.

Generally, the partnership agreement determines a partner's distributive share of any item or class of items of income, gain, loss, deduction, or credit.

However, the allocations provided for in the partnership agreement or any modification will be disregarded if they do not have substantial economic effect.

If the partnership agreement does not provide for an allocation, or an allocation does not have substantial economic effect, the partner's distributive share of the partnership items is generally determined by the partner's interest in the partnership.

For special allocation rules for items attributable to built-in gain or loss on property contributed by a partner, see Contribution of Property under Transactions Between Partnership and Partners, later. An allocation has substantial economic effect if both of the following tests are met.

Allocation attributable to a nonrecourse liability. An allocation of a loss, deduction, or expense attributable to a partnership nonrecourse liability does not have any economic effect because the partner does not bear the economic burden corresponding to that allocation.

(See Effect of Partnership Liabilities under Basis of Partner's Interest, later.) Therefore, the partner's distributive share of the item must be determined by his or her interest in the partnership.

For example, the partner's share of the partnership gross income is used in determining whether an income tax return must be filed by that partner. Partners may have to make payments of estimated tax during the year as a result of partnership income. The partner's distributive share of ordinary income from a partnership is generally included in figuring net earnings from self-employment.

Generally, estimated tax for individuals is the smaller of the following amounts, reduced by any expected withholding and credits. However, a limited partner generally does not include his or her distributive share of income or loss in computing net earnings from self-employment.

Under the partnership agreement, profits and losses are shared in proportion to each partner's contributions.

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