Computing tax obligations when a partner liquidates his partnership interest can be simple or extremely complex. The tax liability will depend on the structure of the partnership agreement and the history of transactions that have occurred with the partners. The sale actually has no effect on the completion of Form 1065 unless the partnership is being liquidated; rather, it is reported through a series of adjustments made on the individual partner's Schedule K-1s.
Complete Part I and Part II, Items E through I, on each partner's K-1. This is used to provide personal information.
Complete Part III of each partner's K-1. This is used to distribute profit and loss to each partner based on the partnership agreement.
Complete the selling partner's K-1. Complete Section J, indicating that at the end of the reporting period the partner's share of the profit, loss and capital accounts have all been reduced to zero. Complete Section K, indicating that at the end of the reporting period the partner's share of the partnership's liabilities has been reduced to zero.
Complete Section L to reflect any increase or decrease in the partner's capital account for the current reporting period and indicate that any remaining balance in the capital account was distributed to the partner. The computation should result in an ending capital account balance of zero. Check the box at the top of the form indicating that this is the partner's "Final K-1".
Complete the remaining partners' K-1s. The remaining partners' profit, loss and capital accounts (Item J) should increase to offset the decrease on the selling partner's accounts according to the partnership agreement. For instance, if the partnership agreement calls for an equal split between all the partners and one of three partners is leaving, the remaining two partners would have their accounts increased by roughly 16.66 percent (half of the 33.33 percent relinquished by the departing partner).
Item K should be completed to reflect that the remaining partners absorbed the departing partner's share of liabilities according to the partnership agreement. For purposes of completing Section L, the liquidation of the partnership interest will have no direct impact on the remaining partners' capital accounts.
It is extremely important to refer to the partnership agreement to determine the correct liquidation procedures for a partner’s interest. The terms can have significant tax implications and should always be spelled out when the partnership is formed.
The structural flexibility of partnerships leads to inherent complexity. It is not advisable to attempt to compute partners' tax obligations without the assistance of a licensed professional.
Things You'll Need
Previous year’s tax return
Completed Form 1065
Schedule K-1 (Form 1065)