When you create a partnership there are tax benefits that come with that decision. When the time comes to dissolve the partnership there are many things that need to be considered for succession planning. The tax consequences when exiting a partnership can be significant and it is important to consider them when making the decision to end the partnership.
How Does Exiting a Partnership Work With Taxes?
Partnerships are unique when it comes to tax entities in that they don't pay taxes on their own. The profits and losses from the partnership are passed to the individual members of the partnership to be filed on their personal tax return. The partnership does file a form 1065 yearly with the federal government to report income. On the state level, taxing of partnership differs from state to state.
When a partnership is formed, the partner each bring something to the table, this is their investment in the partnership known as the tax basis. When the partnership is dissolved this is the amount that each of the partners takes from the business. Many factors affect the amount of the basis, including depreciation and appreciation, you need to figure the adjusted basis to determine the value of your holding in the partnership.
When you decide to exit a partnership there are three things that need to be done:
- Sell the assets of the partnership
- Pay any outstanding debt
- Distribute what remains between the partners.
Sell the assets
When a partnership is ended, the partners can't just divide up the assets and call it a day. The assets of the partnership (cash and property) must be liquidated. They must be sold or otherwise disposed of and the results must be accounted for.
Pay Outstanding Debts
After all the assets have been accounted for, any outstanding debts must be taken care of. If there is not enough money to pay the outstanding debt then the partners must each contribute the necessary money to clear the debt.
If there is money remaining, this is distributed to the partners and this is where there may be partnership termination tax consequences.
The tax year-end for a partnership that has been terminated is the day the partnership stops doing business. Since the taxes for a partnership are run through the individual partner's personal taxes, the termination of the business can have an effect on the amount of taxes that will have to be paid. If the partnership was profitable, the gains will add to personal income, if the partnership suffered a loss then the personal income of the partners will be reduced. The actual gain is figured by reducing the amount received at the distribution by the amount of the tax basis.
Because a partnership is not a tax entity on its own, for most people exiting a partnership the consequences will be minimal unless the business has been very successful and the amount of gain at the distribution is very high. If you are considering exiting your partnership, it is important to discuss it with accounting professionals, like the experienced staff at Chandler & Knowles CPAs who will help you to decide the best timing for ending your partnership through our business consulting services.