Key Takeaways

  • Partnership distributions do not have to be equal, provided the partnership agreement outlines an alternative allocation.
  • Distributions can include profits, return of capital, and loans, each with different tax implications.
  • Distributions must follow “substantial economic effect” rules under IRS guidelines.
  • Tax basis and timing significantly affect how distributions are treated for tax purposes.
  • Special rules apply to disguised sales, guaranteed payments, and disproportionate distributions.
  • A well-drafted partnership agreement is essential to avoid unintended tax consequences.

Do partnership distributions have to be equal? Partner equity does not typically equate to equivalent investment contributions from all business partners. Instead, partners can make equal contributions to the company and possess equal ownership rights, but make contributions in a variety of different forms.

What Are the Three Common Ways to Take Money out of a Partnership?

There are three standard ways to take funds out of a partnership:

  • Return of capital: Refers to principal payments back to the partners that exceed the growth of a business or investment.
  • Distribution of income: The process of sharing the net income of a partnership between the partners in a proportion that aligns with the partnership agreement.
  • Loan to partner: Refers to the process of borrowing money from the capital of the partnership.

What Are the Allocation Methods Used to Distribute Partnership Income?

In order to distribute partnership income, there are a number of ways to allocate the funds. These include:

  • Specified ratios,
  • Partners' service contributions,
  • Partners' relative capital investments.

A combination of all of the different allocation methods can also be used.

What Is the Most Common Allocation Method?

The most common way partners allocate net income is through the relative capital investment of each individual. To clarify, if partner A and B each supply 50 percent of the capital then each person will receive 50 percent of the company's net income.

Is Unequal Distribution of Profits Allowed?

A partnership agreement may specify that unequal profit percentage is available to a partner and isn't dependent on the amount of his/her capital distribution. For example, if partner A and partner B both make initial capital contributions of 50 percent each, a partnership agreement can document the understanding that partner A receives 40 percent of the net profit while partner B receives 60 percent.

How Unequal Distributions Must Comply with IRS Rules

While partnership distributions do not have to be equal, they must follow IRS rules to avoid recharacterization. Unequal profit sharing is permitted only if it satisfies the “substantial economic effect” requirement under IRC Section 704(b). This means:

  • The allocation must be reflected in the partners’ capital accounts.
  • Upon liquidation, distributions must align with the balances in those capital accounts.
  • Any allocation must have a real economic impact on the partners, not just be a tax-avoidance mechanism.

Failing to meet these standards may result in the IRS reallocating income and expenses in proportion to each partner’s interest in the partnership, which could trigger unexpected tax liabilities.

What Should Be Set up to Record Loans to Partners From the Partnership?

Borrowing from a partnership is allowed. This is completed by setting up a notes receivable account in order to record any loans that a partner takes from the partnership. The borrowing partner should prepare and sign a promissory note. The note should contain specific items regarding the loan, such as:

  • The principal (the amount financed),
  • Repayment date(s),
  • Interest rates,
  • Late payment penalties,
  • Installment payment amounts.

Another option when taking money out of a partnership is to reclaim all or part of the initial capital investment.

Is a Return of Your Capital Taxable?

Returned capital is also not taxable. It is important to note that if you do decide to liquidate the partnership and receive an amount that is more than your capital investment, the excess is considered capital gain. It is considered a capital loss if you receive less than your initial investment.

Timing and Basis Adjustments for Current Distributions

A partner must calculate their tax basis both before and after receiving a distribution. Basis is reduced by the amount of cash or the adjusted basis of property received. If a distribution exceeds the partner’s outside basis, the excess is treated as a capital gain.

Here are some timing considerations:

  • Basis must be determined immediately before the distribution.
  • Partners may not deduct losses if their basis is insufficient.
  • Current (non-liquidating) distributions generally are not taxable until they exceed the partner’s basis.

Distributions are presumed to be current unless the partner receives a complete liquidation of their interest.

Tax on Retained Earnings in a Partnership

In a partnership, the income passes through to the partners. This means that a partnership does not pay taxes, but rather the partners do. In fact, it is the responsibility of the partners to ensure that they pay tax on their income. Remember that what the Internal Revenue Service (IRS) considers income and what the members of a partnership declare as income may be widely different, especially when it comes to retained earnings. This refers to funds that have been generated by the business, but not taken out from the partners.

Special Types of Distributions and Their Implications

There are various types of partnership distributions beyond standard profit allocations:

  1. Guaranteed Payments: These are payments made to a partner for services or use of capital, regardless of partnership income. They are treated as ordinary income to the recipient and are deductible by the partnership.
  2. Disguised Sales: If a distribution is part of a larger transaction that resembles a sale (e.g., a partner contributes property and soon after receives a large distribution), the IRS may treat it as a taxable sale.
  3. Non-Liquidating vs. Liquidating Distributions: Non-liquidating distributions reduce a partner’s basis but do not end the partnership interest. Liquidating distributions fully extinguish the partner’s interest and may result in capital gain or loss, depending on the final basis and amount received.
  4. Property Distributions: If a partnership distributes appreciated property, the partnership may not recognize gain, but special basis adjustment rules apply.
  5. Disproportionate Distributions: If a distribution disproportionately allocates ordinary income-producing assets (like inventory or unrealized receivables), it may trigger gain recognition under IRC Section 751(b).

Understanding these nuances helps avoid surprises during tax season or an IRS audit.

Retained Earnings as Income

When members leave profits in the partnership rather than withdrawing them, this is referred to as retained income. The IRS states that partners must pay taxes on this generated income because it is considered as distributed funds. Leaving retained profits in the business doesn't exempt the funds from being taxed. This is because partnerships do not get taxed, but the partners do. All retained earnings should be filed on each partner's Form 1040, which is one of three different IRS forms utilized for filing individual federal income tax returns.

Filing Form K-1 and Form 1065

There are specific forms that a partnership must complete when filing taxes. For example, a partnership must file a Schedule K-1 with the IRS and provide a copy to each partner. The Schedule K-1 Form reports each member's share of the losses and profits. These figures must correlate to members' claims on their personal income tax forms. The IRS will also require the partnership to complete Form 1065 to determine if all the partners are appropriately reporting their income.

Common Mistakes in Partnership Distributions

Even sophisticated partnerships can encounter problems with distribution practices. Common mistakes include:

  • Failing to track basis: Distributions may be misreported if partners or the partnership do not properly monitor basis.
  • Ignoring disguised sale rules: Close-in-time contributions and distributions may inadvertently trigger sale treatment.
  • Incorrect capital account maintenance: Misalignments in capital accounts may lead to IRS challenges under the substantial economic effect rules.
  • Improper documentation: Without a clearly drafted partnership agreement, it's difficult to justify unequal allocations or special allocations to the IRS.

To mitigate risk, partners should maintain meticulous records and consult with a tax attorney or CPA. If you need assistance determining whether partnership distributions have to be equal and how to structure them, you can post your legal need on UpCounsel to connect with experienced business attorneys.

Frequently Asked Questions

  1. Do partnership distributions have to be equal among partners?
    No. As long as the partnership agreement authorizes it and it meets IRS guidelines for substantial economic effect, distributions can be unequal.
  2. Can a partner receive a distribution even if the partnership has no profits?
    Yes. Partners can receive return-of-capital distributions or loans, but tax consequences vary based on their basis and the type of distribution.
  3. What happens if a distribution exceeds a partner's basis?
    Any distribution amount exceeding the partner’s basis is treated as a capital gain.
  4. Are guaranteed payments considered distributions?
    Not exactly. Guaranteed payments are a separate category and are treated as ordinary income, even if the partnership has no profits.
  5. What’s the difference between a current and liquidating distribution?
    A current distribution does not end a partner’s interest in the partnership. A liquidating distribution terminates the partner’s entire interest and may trigger capital gain or loss.

If you need determining if partnership distributions have to be equal, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.