Tax Planning for Partnerships: Distributions and Basis
By SimplyCPA · 11 October 2026
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- Basis is the gatekeeper: It limits both deductible losses and tax-free cash distributions — plan contributions, loans and liability allocations around it.
- Liability shifts: A reduction in a partner's share of liabilities is a deemed cash distribution that can trigger gain.
- Disguised sales: A contribution followed by a distribution to the same partner within two years is presumed to be a sale.
- Section 754 election: Lets the partnership adjust inside basis on transfers and distributions, so a buying partner isn't taxed on gain it already paid for.
- Hot assets and mixing bowls: Distributions that shift unrealised receivables or inventory trigger ordinary income, and distributing contributed built-in-gain property within seven years triggers gain to the contributor.
1. Manage outside basis before taking losses or cash
A partner can deduct losses only up to outside basis, and receives cash tax-free only up to outside basis. Ways to increase basis before year-end:
- Contribute additional cash or property.
- Increase the partner's share of partnership liabilities — for example, by personally guaranteeing recourse debt, which shifts the economic risk of loss (and the liability allocation) to that partner.
- Time distributions after the year's income allocation, since basis is increased for income before distributions are tested at year-end.
2. Watch for deemed distributions
Paying off partnership debt, refinancing, or admitting a new partner can reduce an existing partner's share of liabilities. That reduction is treated as a cash distribution and is taxable if it exceeds the partner's basis — a common trap when partnerships with depreciated real estate restructure their debt.
3. Avoid disguised sales (Section 707)
If a partner contributes property and the partnership distributes money or other property to that partner within two years, the transactions are presumed to be a sale unless the facts clearly show otherwise. Exceptions include reasonable guaranteed payments, preferred returns and operating cash flow distributions. Distributions after two years are presumed not to be a sale.
4. Use the Section 754 election
| Situation | Adjustment | Benefit |
|---|---|---|
| A partner buys an interest from another partner (Section 743(b)) | The buyer gets a special basis adjustment to its share of inside basis | Extra depreciation, and less gain when the partnership sells appreciated assets |
| The partnership distributes property and recognises gain, or a partner's basis in distributed property changes (Section 734(b)) | Adjusts the basis of remaining partnership property | Keeps inside and outside basis aligned |
A mandatory adjustment applies anyway if the partnership has a substantial built-in loss (over $250,000).
5. Hot assets (Section 751)
When a partner sells its interest, or receives a disproportionate distribution, the portion attributable to unrealised receivables and inventory items is taxed as ordinary income, not capital gain. Depreciation recapture counts as an unrealised receivable.
6. Mixing-bowl rules
- Section 704(c)(1)(B) — if contributed property with built-in gain is distributed to another partner within seven years, the contributor recognises the built-in gain.
- Section 737 — if the contributor receives other property within seven years, it recognises gain up to the lesser of the excess distribution or the remaining built-in gain.
7. Guaranteed payments vs allocations
A guaranteed payment gives the partner ordinary income regardless of partnership profit and is generally deductible by the partnership. A larger allocation of profits instead keeps the income's character (for example, capital gain) but depends on the partnership being profitable. Allocations must have substantial economic effect to be respected.
Example: A partner with $40,000 of outside basis expects a $60,000 share of losses this year. A $25,000 cash contribution before year-end — or guaranteeing $25,000 of partnership debt — increases basis to $65,000, allowing the full loss (subject to at-risk and passive limits) instead of suspending $20,000.
Start with partnership taxation basics.