Discussion:Partnership distributions - double header

1) Partner withdraws funds in excess of basis. This was taken as a withdrawal against future income without any intent to partially liquidate his interest. We are going to report it as income on his 1040 (we have filed for an extention). My best understanding after some research is that it gets handled as LT cap gain using a zero basis. It seems unreasonable to me that IRS would allow this to be taxed at a capital gains rate where no partnership interest was disposed of. I would think that its ordinary income subject to SE tax (which I am sure would satisfy IRS), but I cannot get a clear reading as to how this gets taxed where there is no reduction in partnership interest or stated another way, no disposition of an asset. I have also read that this income does not go on K-1.

2) The accounting side of this question is as follows: The balance sheet presently shows a debit balance of ($5000) in the partners capital account, as a result of the withdrawal mentioned in part one. In reporting the $5000 as income, it should allow me to clear the negative balance and bring it back to zero. The question is "what is the complete journal entry" ? I obviously will credit the partners capital account by $5000 but what is the offset account ? My understanding is that in this situation the partnership as an entity does not report any loss. If thats correct, the offset account cannot flow to the Income Statement or for that matter get posted directly against retained earnings.

Negative Capital Account

A partner may have a negative capital account but can never have a negative basis. The partnership basis rules specifically prohibit reduction of a partner's basis below zero. There is no similar limit with respect to a partner's capital account.

A negative capital account can result from a number of adjustments. For example, deductions or losses attributable to liabilities may reduce a partner's capital account below zero. EXAMPLE Smith contributed $100 to partnership P and received a 50-percent partnership interest in P. P used Smith's $100, the $100 contributed by other partners and the proceeds of an $800 nonrecourse (interest only) loan to buy a building. During the first ten years of operations, P suffers a $360 loss, $180 of which is allocable to Smith. At the end of ten years, Smith has a $320 basis in his interest ($100 plus one-half of the $800 liability, less his $180 share of P's losses), and a capital account of negative $80 ($100 less his $180 share of P's losses). Distributions also can create a negative capital account. A partner must reduce his capital account by the full amount of the distribution even though the distribution reduces the capital account below zero. A partner's basis for his partnership interest cannot, however, be reduced below zero. A distribution of money in excess of a partner's basis reduces the basis to zero and the partner recognizes gain to the extent of the excess amount. A distribution of property in which the partnership has a basis that exceeds the partner's basis in his interest reduces the partner's basis to zero, and the partner's basis in the distributed property equals his basis in his interest immediately before the distribution. EXAMPLE Smith, Jones and Brown each contribute $100 to partnership P in exchange for a one-third partnership interest. P purchases a stock for $300. When the stock appreciates to $900, P borrows $600 and distributes $200 to each partner. Each partner's basis in his interest remains at $100 ($100 contribution plus $200 share of the borrowing less the $200 distribution), but his capital account is negative $100 ($100 contribution less the $200 distribution). Relief from indebtedness may create a negative capital account. In this respect, relief from partnership indebtedness has the same tax effect as a distribution of cash in an amount equal to the relieved indebtedness.

Code Secs. 705(a)(2), 733. Reg. §1.704-1(b)(2)(ii)(f). Reg. §1.704-1(b)(2)(iv). Reg. §1.704-1(b)(2)(iv)(b)(4), (5). Code Sec. 733. Code Sec. 731(a)(1). Code Sec. 732(a)(2); Code Sec. 732(b). Reg. §1.752-1(c).

Derrick

I did not post the transaction which resulted in the CA falling below zero. I was called in to review the books and try to straighten things out. The partner had no remaining basis and his CA should have been zero. He received a check our of the cash account and whoever issued it, incorrectly posted it to the balance sheet as a debit to Partner CA and a credit to cash. So the journal entry was incorrect as it created a negative CA balance. I am left with a decision as to how to address the issue. I could reallocate it as a loan from the partnership to the partner, but prefer not to as their are no supporting promissory notes or interest payments being made. I am instead inclined to report it as income to the partner for 2007, but that leads me back to my initial questions. How is it properly taxed on the partners 1040 and if I credit CA to bring it to zero, what is the offset ? I could pick it up as a guaranteed payment, or perhaps create a GL account on the Income statement called "Withdrawals or Distributions w/o basis". The expense of course would then flow to the partnership.

Marcilio, please reconsider my initial questions in light of my comments here. Hopefully, it gives you a better picture.

I think I would be scratching my head the same as you are if I had to look for a different solution. I think if you declare that this is the way to handle it, they will agree.