When you dissolve or liquidate a partnership, you need to file a final annual partnership return for federal income tax purposes. You would check the box for “final return” at the top of Form 1065, U.S. Return of Partnership Income. Since a partnership is a pass-through entity for federal income tax purposes, each partner’s proportionate share of the partnership’s income, deductions and credits for the final period, including any capital gains or losses on sales of partnership assets would be reported on the partners’ individual tax returns.
According to the IRS, a partnership terminates when all its operations are discontinued and none of the partners continue any part of the business or financial operation of the partnership. In this case, for federal income tax purposes the termination date is the date when the partnership completes the winding up of its affairs.
A partnership also terminates if at least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner. In this case the termination date is the date on which at least 50% of the total interest has been sold or exchanged, either in one transaction or in combination with other sales or exchanges during the 12-month period.
The termination date would also be the end of the partnership’s tax year. If that date is prior to the normal ending date of the partnership’s tax year, a federal income tax return would have to be filed for the short period. The partnership tax return would be due on the 15th day of the fourth month after the date of termination.
The IRS points out that converting a partnership into a limited liability company (LLC) does not terminate the partnership for federal income tax purposes. The partnership’s tax year does not close and the LLC can continue to use the partnership’s taxpayer identification number if the LLC is classified as a partnership for federal income tax purposes.
When a partnership is converted to an LLC, recourse liabilities may become nonrecourse liabilities. This could affect the partners’ bases in their partnership interests. According to the IRS, if as a result, the decrease in a partner’s share of the liabilities exceeds the partner’s basis, that partner would have to recognize a gain on the excess for federal income tax purposes.
Normally, distributions to partners do not affect the partnership’s allocation of income and deductions to the partners. A distribution would reduce the partner’s basis in his or her partnership interest and the partnership would not recognize any gain or loss on the distribution. But a distribution could be considered a sale or exchange when it involves unrealized receivables or substantially appreciated inventory items. Inventory items are considered to be substantially appreciated when their fair market value at the time of the distribution is more than 120% of the partnership’s adjusted basis in the items. The IRS points out that when a partner receives money or property in exchange for the partner’s interest, the amount that corresponds to the partner’s share of unrealized receivables or inventory would result in ordinary income or loss.
A partner would generally recognize gain on a distribution from the partnership only if any money or marketable securities received in the distribution exceed the partner’s adjusted basis in the partnership interest. The gain would generally be considered a capital gain. If property is distributed, the partner would not recognize any gain for tax purposes until the partner sells or disposes of the property received in the distribution.
According to the IRS, a partner could only realize a loss for tax purposes on a partnership distribution if the adjusted basis of the partner’s interest is more than the distribution, the partner’s entire interest is liquidated, and the distribution is in the form of money, unrealized receivables, or inventory items. The basis of the property that a partner receives in a complete liquidation of the partner’s interest is the adjusted basis of the partner’s interest reduced by any money received.
There may be other federal tax reporting requirements when you dissolve or liquidate a partnership, for example if the partnership has employees. The IRS provides a Closing a Business Checklist that can serve as a useful reference.
Closing a Business Checklist, IRS
Form 1065, U.S. Return of Partnership Income, IRS
Instructions for Form 1065, IRS
Publication 541, Partnerships, IRS