Original air date: Dec. 14, 2017 Recording available at http://www.mhmcpa.com Partnerships often hear the calling from private equity fund partners to monetize a portion of the value they own, even though they are not yet ready to deploy their exit strategy. Partnerships offer tremendous flexibility to accomplish this objective in a tax-efficient manner using debt-financed distributions. However, these transactions leave potential traps for the unwary. In this webcast, we will provide comprehensive examples of the tax consequences of debt-financed distributions, from the moment they are made through typical subsequent events that affect their tax results.

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CBIZ & MHM
Executive Education Series™
Tax Considerations for Debt Financed
Distributions from Partnerships
Nate Smith, National Tax Office
December 14, 2017

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About Us
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MHM (Mayer Hoffman McCann P.C.) is an independent CPA firm that provides audit, review and attest services, and works closely with CBIZ, a business consulting,
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Disclaimer
The information in this Executive Education Series
course is a brief summary and may not include all
the details relevant to your situation.
Please contact your service provider to further
discuss the impact on your business.

6. CBIZ & MHM 6
Nathan Smith is a Director in the CBIZ National Tax Office, bringing over
19 years of experience in public accounting to provide technical support
and strategic solutions for the firm’s tax practice. Nathan leads the
development of practice aids and tactical approaches used in
responding to industry and Federal tax developments in a variety of
subject matter areas. Nathan also consults nationally to facilitate
delivery of client service opportunities and solutions, contributes as an
author and editor to the firm's tax thought leadership publications and
assists with the development and implementation of national tax
policies and procedures.
727.572.1400 • nate.smith@cbiz.com
Nathan Smith, CPA
Director
Presenter

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Agenda
Overview of Benefits from Debt-Financed Distributions
02
01
03
04
Discuss Current and Liquidating Partnership Distributions
Understand the Role Basis Plays and How It Is Calculated
Interaction of Partnership Debt with Basis and Distribution Techniques
Allocations of Partnership Debt
Examples
05
06

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OVERVIEW OF BENEFITS FROM
DEBT-FINANCED DISTRIBUTIONS

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Overview of Debt-Financed Distributions
• Partners in partnerships often desire to monetize
some of their investment but are not ready to sell
their entire partnership interest
• Significant owners (private equity, original founders)
want to maintain control
• Additional upside potential still exists
• Current cash needs from owners
• Partnerships can offer unique strategies to accomplish
these goals that are not available to other business
types

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Overview of Debt-Financed Distributions
• Debt-financed partnership distributions provide
current cash flow to the partners, while allowing such
partners to maintain their interests in partnership
profits and relative claims to partnership capital
• Better yet, debt-financed distributions can provide for
this result without any incursion of tax liability in the
year of the distribution
• BUT, partners must understand and remember the
future tax consequences of this strategy

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CURRENT AND LIQUIDATING DISTRIBUTIONS

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Current and Liquidating Distributions
• In a partnership, ALL distributions are treated as
“current” distributions, except for those that are
made to liquidate entirely the distributee’s
partnership interest
• Current distributions include the following, regardless
of the extent to which a partner’s interest in capital
and/or profits may be reduced, as long as it is not
reduced entirely:
• Pro rata and non-pro rata distributions of current
earnings
• Pro rata and non-pro rata distributions of capital
investments

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Current and Liquidating Distributions
• Current distributions do not produce taxable gain to the
distributee partners, except when the amount of money
received by such partners exceeds the tax basis of the
partnership interest
• Partners reduce the tax basis of the partnership interest by the
amount of money received in current distributions
• Liquidating distributions are taxed to the distributee partners
in a similar way, but unlike current distributions, liquidating
distributions:
• Provide for loss recognition to the distributee if the distribution
consists solely of money and certain other assets, and is less than
the distributee’s tax basis
• Can be treated as retirement payments in certain situations
(taxed as ordinary income to the distributee)
• Provide for substituted basis when consisting of property
distributions

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Current and Liquidating Distributions
• Current distributions produce a taxable gain to the
distributee partner in circumstances where the
amount of the distribution exceeds the partner’s basis
in his or her partnership interest
• The gain is treated as one from the sale or exchange
of a partnership interest, so absent any special
exception (e.g., hot asset rules under Section 751),
the gain will be capital in nature

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Current and Liquidating Distributions
• Example
• The partnership Reggie’s Diner, LLC is owned 1/3-each by
partners George, Jerry, and Cosmo. The partnership
originally was formed by contributions of $100,000 cash
from each partner. The partners’ capital and profits
interests in the partnership are pro rata in this regard. After
several years of break-even operations, each partner’s tax
basis in his Reggie’s Diner partnership interest is $100,000,
and the fair value of each partner’s interest is $250,000.
Reggie’s Diner has no property to which §751 applies, and is
a debt-free entity. Reggie’s Diner does not have a §754
election in effect. George then receives $125,000 cash,
reducing his stake in Reggie’s Diner from 1/3 to 1/5.

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Current and Liquidating Distributions
• Example (cont’d)
• George recognizes a capital gain of $25,000 on his
receipt of this cash, which is treated as a current
distribution.
• Obviously, understanding the concept of basis and
how to calculate it is crucial in determining whether
distributions are taxable

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TAX BASIS IN PARTNERSHIP INTERESTS

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Tax Basis in Partnership Interests
• Tax basis (sometimes referred to as “tax capital” or
“outside basis”) in a partner’s partnership interest is
the mechanism by which a partner is not taxed twice
on partnership profits, or on the value of his or her
initial investment
• Tax basis in a partnership interest essentially provides
for a form of cost recovery to offset realized gains
from the partnership investment, or to give partners
the wherewithal to deduct partnership losses

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Tax Basis in Partnership Interests
• A partner’s tax basis in his partnership interest
initially is established by the amount of money and
the adjusted basis of any property contributed by him
or her to the partnership, or by his or her cost of such
partnership interest if acquired from another partner
• A partner’s distributive share of partnership income
or losses then increases or decreases this tax basis

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Tax Basis in Partnership Interests
• Current distributions of money also decrease a
partner’s tax basis in his or her partnership interest
• As illustrated in the previous example, gain must be
recognized for distributions in excess of basis
• So . . . how do debt-financed distributions of money
result in a different answer?
• One more nuance of tax basis in the partnership interest
is in order – partnership debt

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PARTNERSHIP DEBT AND INTERACTION WITH BASIS

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Partnership Debt and Interaction with Basis
• A partner’s tax basis in his or her partnership interest
also includes any increase in the partner’s share of
the partnership’s liabilities, or any increase in the
partner’s individual liabilities by reason of the
assumption by such partner of partnership liabilities
• This is so because each is considered for tax purposes
to be a contribution of money by such partner to the
partnership
• The deemed contribution of money therefore provides
an increase to the tax basis of the partner’s partnership
interest

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Partnership Debt and Interaction with Basis
• For purposes of applying this concept concerning the deemed
contribution of money, Section 752 does not distinguish
between recourse and nonrecourse debt
• An allocation of nonrecourse partnership debt provides just as
much tax basis to a partner as does recourse debt
• As will be seen later, there are different rules used to determine a
partner’s share of recourse debt and non-recourse debt; while
such distinctions are important to determine a partner’s share of
each, both types are treated as a deemed contribution of money
(increasing a partner’s tax basis)
• The converse of the deemed contribution principle applies as
well – a deemed distribution of money occurs when a partner’s
share of partnership liabilities decreases, or when a partner’s
individual liabilities decrease by reason of the assumption by
the partnership of such individual liabilities

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Partnership Debt and Interaction with Basis
• As can be seen, a partner’s “share” in the liabilities of
a partnership is a critical factor in the determination
of each partner’s tax basis in his or her partnership
interest
• When a partner is determined to share in partnership
debt, his or her tax basis in his partnership interest is
increased by treating his or her share as a deemed
contribution of cash
• With this increased basis, a subsequent distribution to
the partner of actual cash will not result in a taxable
gain (to the extent of such increased basis)

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Partnership Debt and Interaction with Basis
• A continuation of the previous example will help with this
point
• The partnership Reggie’s Diner, LLC allocates profits 1/5 to
George, 2/5 to Jerry, and 2/5 to Cosmo after the previous
transaction. The partners’ tax bases in their partnership
interests are $0, $100,000, and $100,000; respectively. In
an effort to monetize most of the remaining fair value of
Reggie’s Diner without liquidating any partner’s interest in
the partnership, the partnership borrows $600,000 from
Chemical Bank (secured only by the going-concern value of
the partnership). Assume that no partner or related person
bears the economic risk of loss for this loan, and that the
partners’ shares of this partnership liability are $120,000,
$240,000, and $240,000; respectively.

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Partnership Debt and Interaction with Basis
• Example (cont’d)
• The partnership immediately distributes the loan proceeds
to its partners, with $120,000 distributed to George,
$240,000 distributed to Jerry, and $240,000 distributed to
Cosmo. Reggie’s Diner has no property to which §751
applies, no other debt, and its only assets are $175,000 of
security deposits. After the distribution, the partners’
profits interests in Reggie’s Diner remain at 1/5, 2/5, and
2/5; respectively. As measured just prior to the distribution
(but after the borrowing), each partner’s tax basis in his
partnership interest is adjusted to $120,000, $340,000, and
$340,000; respectively. The distribution proceeds then
reduce each partner’s tax basis in his partnership interest to
$0, $100,000, and $100,000; respectively.

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Partnership Debt and Interaction with Basis
• Example (cont’d)
• Note that neither George, Jerry, nor Cosmo recognize
any gain as a result of their receipt of the debt-financed
distribution. They all continue to own the same
partnership interests just as they had prior to their
receipt of cash, without having sold any partnership
assets to fund the cash distribution.
• Obviously, the determination of how partners share in
partnership liabilities drives the great outcome in the
previous example

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ALLOCATIONS OF PARTNERSHIP DEBT

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Partnership Debt and Interaction with Basis
• A partner’s share in partnership liabilities depends on
the nature of the liability (recourse vs. non-recourse)
and the nature of the partnership (general or limited)
• A liability is recourse with respect to a partner when
such partner bears an economic risk of loss for the
liability
• Conversely, a liability is non-recourse when no
partner bears an economic risk of loss for the liability
• In the context of today’s discussion, we will focus only
on the rules for non-recourse liabilities, as those are
the type typically involved with debt-financed
distributions

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Partnership Debt and Interaction with Basis
• A partner’s share of the partnership’s non-recourse
liabilities equals his or her share of liabilities among
each of three types (tiers) of partnership debt
• Tier one – the partner’s share of partnership minimum
gain that is determined under Section 704(b)
• Tier two – the amount of taxable gain that would be
allocated to the partner under Section 704(c) if the
partnership were to sell its property encumbered by a
liability for consideration equal to the amount of the
liability
• Tier three – excess nonrecourse debt not categorized
under the first two tiers

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Partnership Debt and Interaction with Basis
• Regarding the first tier, partnership minimum gain is:
• The amount of gain the partnership would recognize if
it were to sell its property encumbered by the liability
for consideration equal to the liability
• A partner’s share of this partnership minimum gain
includes (among other things) the amount of
distributions made to the partner (and his or her
predecessors in interest) out of proceeds from the
non-recourse debt

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Partnership Debt and Interaction with Basis
• In a continuation of the previous example:
• The partnership has $600,000 of minimum gain, since the
going concern value of the partnership (an asset in which
the partnership has a $0 tax basis) is the only asset that
secures the $600,000 loan (also recall, the proceeds of the
loan were distributed out to the partners)
• Remember, this minimum gain is a concept used to determine
liability allocations, and does not denote any currently taxable
element on the prior cash distribution to the partners
• It then follows that George, Jerry, and Cosmo share in this
minimum gain $120,000, $240,000, and $240,000;
respectively (since these are the respective distributions of
loan proceeds that fed the partnership minimum gain)
• The partners’ shares of this minimum gain therefore is
tantamount to their allocations of the nonrecourse liability
under ‘tier one’

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Partnership Debt and Interaction with Basis
• The rules for allocations of partnership liabilities
under ‘tier two’ or ‘tier three’ are beyond the scope
of today’s discussion
• Also beyond the scope of today’s discussion, debt-
financed distributions that occur during or proximate
with contributions of property to a partnership are
sometimes treated as proceeds in a disguised sale of
such property to the partnership
• New temporary regulations govern the allocation of
recourse and non-recourse debt in such situations,
which serve to limit the amount of debt that can be
used to diffuse a potential disguised sale

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Partnership Debt and Interaction with Basis
• So to regroup, the rules for partnership non-recourse
debt allocations under ‘tier one’ provide that partners
often share in the partnership’s debt in an amount
identical to the debt-financed distribution proceeds
that the partners received
• Because a partner’s tax basis is increased by this
amount of partnership debt, the simultaneous
decrease to the partner’s tax basis that results from
the distribution of money produces no taxable gain

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Partnership Debt and Interaction with Basis
• Although partners in this situation are beneficiaries of
a highly tax-advantaged result in the year of the
distribution, they must be mindful of inescapable
future tax consequences
• Recall that a deemed distribution of money occurs
when a partner’s share of partnership liabilities
decreases
• The same principle also holds true when a partner
sells his or her partnership interest in a later year,
except the partner’s decreased share of partnership
liabilities is counted as additional sales proceeds

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Partnership Debt and Interaction with Basis
• In either of those cases, the partner’s additional proceeds
deemed to exist will be taxable to the partner
• Same result could theoretically occur if the loan was merely
repaid, without some other partnership item to backfill the
partners’ tax basis of their partnership interests (such as
taxable income allocations)
• Hence, the tax-free answer accomplished in the year of a
debt-financed distribution is more aptly described as a
tax-deferred solution, whereby the tax consequences are
merely deferred to the later year when the partner’s
allocation of non-recourse debt decreases
• Partners must be vigilant in understanding this concept,
so that tax surprises do not result in the later year

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Partnership Debt and Interaction with Basis
• Let’s consider one last continuation of the example:
• The partnership Reggie’s Diner, LLC is owned 1/5 by
George, 2/5 by Jerry, and 2/5 by Cosmo. The partners’
tax bases in their partnership interests are $0,
$100,000, and $100,000; respectively. These tax bases
were adjusted for the previous debt-financed
distribution. As such, the tax bases already include an
allocation of nonrecourse liabilities to each partner of
$120,000, $240,000, and $240,000; respectively (some
might refer to each partner’s partnership interest as
being “upside down,” since the debt allocated to each
partnership interest exceeds the outstanding adjusted
tax basis).

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Partnership Debt and Interaction with Basis
• Example (cont’d):
• Several months after the debt-financed distribution, the
partners agree to admit Newman as a new partner with a
1/4 profits interest in Reggie’s Diner, in exchange for future
delivery services to be provided to Reggie’s Diner by
Newman. As a result, the partners’ capital interests in
Reggie’s Diner remain unchanged, and the partners’ profits
of Reggie’s Diner are now shared 3/20 by George, 3/10 by
Jerry, 3/10 by Cosmo, and 1/4 by Newman. The profits
interest granted to Newman generally is nontaxable. Even
though the partners’ profits interests have shifted, the
Reggie’s Diner debt remains as a ‘tier one’ nonrecourse
liability, and as such, is allocated $120,000 to George,
$240,000 to Jerry, $240,000 to Cosmo, and $0 to Newman.
(Rev. Proc. 93-27, 1993-2 C.B. 343)

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Partnership Debt and Interaction with Basis
• Example (cont’d):
• The shifts in profit ratios among the partners do not
necessarily have any bearing on the nonrecourse
liability allocations to the partners, which is important
here since the original partners need to maintain such
liability allocations in order to perpetuate the tax
deferral on their debt-financed distribution proceeds.
As this debt-financed distribution ‘aftermath’ goes, so
far so good.
• But, now consider the following . . .

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Partnership Debt and Interaction with Basis
• Example (cont’d):
• The capital of the partnership Reggie’s Diner, LLC is
owned 1/5 by George, 2/5 by Jerry, 2/5 by Cosmo, and
0 by Newman. The partners’ profits of Reggie’s Diner
are shared 3/20 by George, 3/10 by Jerry, 3/10 by
Cosmo, and 1/4 by Newman. The partners’ tax bases in
their partnership interests are $0, $100,000, $100,000,
and $0; respectively. These tax bases were adjusted for
the previous debt-financed distribution. As such, the
tax bases already include an allocation of nonrecourse
liabilities to each partner of $120,000, $240,000,
$240,000, and $0; respectively.

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Partnership Debt and Interaction with Basis
• Example (cont’d):
• Several years of partnership operations transpire, in which
partnership profits are generated and completely
distributed to each partner in accordance with their profit
sharing ratios. The $600,000 loan from Chemical Bank does
not require debt-service payments until a later date. As
such, the capital and tax basis for each partner’s partnership
interest remains the same. Assume Reggie’s Diner does not
own any property to which §751 applies. Cosmo then
tenders his partnership interest to Newman for no cash
consideration. Cosmo’s debt allocation of $240,000
decreases to zero, which is treated as cash realized on the
sale of his partnership interest to Newman. Cosmo
therefore realizes $140,000 of capital gain upon the sale of
his interest to Newman. §752(d); Regs. §1.752-1(h).

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Partnership Debt and Interaction with Basis
• Note in the previous example that the seemingly
innocuous transfer (perhaps from the partner’s
perspective) results in a taxable gain in this later year,
which may surprise the transferor partner
• Although beyond the scope of today’s discussion,
shifts in the debt allocations among the partners (i.e.,
without sales or exchanges of partnership interests
involved) also can have tax consequences to the
partners relieved of such debt
• In many cases, the tax consequence of such shifts is an
allocation of ordinary income (not capital gain) to the
partner experiencing a decrease in allocated debt

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Partnership Debt and Interaction with Basis
• Other transactions occurring subsequent to a debt-
financed distribution also can bring about unexpected
tax results to the impacted partners
• Regardless, debt-financed distributions provide a
unique opportunity to partners in partnerships
(particularly for private equity owners looking to
monetize some portion of an original investment)
• Such partners just need to be mindful of the tax
consequences in years subsequent to the original
distribution

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QUESTIONS

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If You Enjoyed This Webcast…
Upcoming Courses:
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• 2/8: Eye on Washington – Quarterly Business Tax Update
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• Survey of middle market private equity executives finds optimism in portfolio
growth
• New Rules, Rule
• Are You Overpaying Your Property Tax?
• Do You Have a Debt Covenant Violation in Your Future?

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