Over the life of a fund, it is likely that a partner will eventually decide to redeem some or all of their interest, and when they do, they may want to take a piece of the portfolio with them rather than cash. A distribution of property in lieu of cash is an in-kind distribution.
These transactions are common, but they demand careful tax planning to mitigate unintended gain recognition, basis distortions, and disguised sale exposure that can arise when a transaction is not structured carefully. Proper planning ensures that both the distributing partnership and the departing partner avoid unnecessary tax burdens and preserve the economic intent of the arrangement.
The Building Blocks of In-Kind Distributions
In-kind distributions are governed primarily by IRC Sections 731, 732, and 733, which serve as the primary authorities. As a general rule, these provisions prevent the recognition of gain or loss by either the partnership or the partner at the time of distribution, except under certain specified conditions.
There are several key reasons a partnership might choose to make an in-kind distribution:
- Preserve cash: Distributing property rather than cash allows the partnership to retain cash for ongoing operations.
- Tax deferral: Such distributions can defer recognition of tax gain until the partner ultimately sells the property, although the partner’s tax basis in the distributed property may differ from the fund’s GAAP fair value used for book capital accounting.
- Flexibility: Partnerships have considerable flexibility in how property is allocated among partners, which differs from the more rigid rules applicable to corporations.
Tax Treatment and Its Exceptions
As noted, in-kind distributions are generally a non-taxable event. However, a few exceptions need to be taken into consideration:
- Gain recognition: If the total amount of cash and marketable securities distributed exceeds the partner’s adjusted basis in the partnership, the partner must recognize gain.
- Hot assets: Distributions of “hot assets,” such as unrealized receivables or appreciated inventory, can trigger ordinary income if the assets are sold within five years.
- Pre-contribution property: Special provisions apply if property contributed by a partner is distributed to a different partner within seven years of the contribution.
After accounting for these potential pitfalls, the next question is whether the partner is taking a partial or full redemption, in other words, a non-liquidating or a liquidating distribution. This distinction can create differing outcomes when the asset lands in the hands of the partner. The key attributes to understand in each scenario are the basis of the property, the holding period, and the gain or loss implications.
Non-Liquidating Distributions
A non-liquidating distribution does not terminate the partner’s interest.
Basis: Generally, the basis of the distributed property is the same as the partnership’s basis immediately before the distribution. However, that basis cannot exceed the partner’s adjusted basis in their partnership interest, reduced by any cash distributed in the same transaction.
Holding period: The partner’s holding period for the distributed property includes the period the partnership held the property.
Recognized gain or loss: Assuming the transaction does not meet one of the exceptions, no gain or loss is recognized by the partner or the partnership.
Example: Suppose a partner has a $100,000 basis in the partnership. The partner receives property with a partnership basis of $60,000 and also receives $20,000 in cash. In this situation, the partner’s basis in the property is $60,000, and the cash received reduces the partner’s outside basis. No gain is recognized unless the cash received exceeds the partner’s outside basis.
Liquidating Distributions
A liquidating distribution terminates the partner’s interest in the partnership.
Basis: One key difference here is that the partner’s basis in property received in a liquidating distribution equals the partner’s outside basis, reduced by any cash distributed in the same transaction.
Holding period: The holding period for the distributed property is the same as that of the partnership.
Recognized gain or loss: Assuming the transaction does not meet one of the exceptions, no gain or loss is recognized by the partner or the partnership.
Example: If a partner’s outside basis is $100,000 and the partner receives $20,000 in cash plus property, the basis in the property is $80,000. If the cash received exceeds the outside basis, the excess is recognized as gain.
Book Treatment and Audit Considerations
From a book perspective, an in-kind distribution is generally accounted for as a capital transaction rather than a sale to the redeeming partner. For an investment company within the scope of ASC 946, investments are measured at fair value, with changes in fair value recognized in operations. Accordingly, before an investment is distributed in-kind, the fund should ensure the investment is carried at fair value as of the distribution date, or the nearest appropriate measurement date, consistent with the ASC 820 fair value framework.
The distribution reduces net assets and the applicable partner’s capital account at the fair value of the asset distributed. Any unrealized appreciation or depreciation on the investment through the date of distribution should be recognized in the statement of operations before the asset is removed from the schedule of investments. The fund should not record a realized gain or loss merely because the asset was distributed, unless the fund’s accounting policy or governing documents support that presentation and the transaction has the substance of a realization event.
Measurement
The investment should be measured using the same valuation policies applied to the fund’s remaining portfolio. For publicly traded securities, this generally means quoted market prices as of the measurement date. For private or illiquid investments, management should apply an ASC 820 valuation technique that reflects market participant assumptions, including relevant calibration, recent transactions, performance updates, market multiples, liquidity considerations, and other significant inputs. If the investment is Level 3, the fund should retain sufficient support for the valuation conclusion and any significant unobservable inputs.
Financial Statement Presentation
In the period of distribution, the asset should be removed from investments at fair value, the partner’s capital account should be reduced for the fair value of the distributed asset, and any related unrealized appreciation or depreciation should be reflected in the statement of operations. If the financial statements include a statement of changes in partners’ capital, the in-kind distribution should be presented as a distribution to partners rather than as a cash distribution.
Disclosure Considerations
The notes should be evaluated to determine whether they need to describe the fund’s policy for in-kind redemptions or distributions, the valuation policy applied to distributed investments, significant Level 3 valuation inputs, and any related party considerations. If the distributed investment was material, illiquid, or subject to significant valuation judgment, enhanced disclosure may be warranted so that users understand how the distribution affected net assets, partners’ capital, and investment activity.
In Practice
Example: Assume a fund distributes a private portfolio investment to a redeeming partner. The investment had a cost basis of $500,000 and a fair value of $650,000 at the distribution date. For book purposes, the fund would first recognize the $150,000 of unrealized appreciation through the statement of operations, remove the investment from the schedule of investments at its $650,000 fair value, and reduce the redeeming partner’s capital account by $650,000. The tax basis and partner-level tax consequences may differ, but the book accounting focuses on fair value measurement, capital allocation, and proper financial statement presentation.
Primary References: ASC 946, Financial Services (Investment Companies), requires investment companies to measure investments at fair value and recognize changes in fair value in earnings. ASC 820, Fair Value Measurement, defines fair value as an exit price and establishes the valuation framework, hierarchy, and disclosure requirements. ASU 2013-08 amended the scope, measurement, and disclosure requirements for investment companies, and ASU 2022-03 clarified the treatment of contractual sale restrictions in measuring the fair value of equity securities.
Key Takeaways
As with all in-kind distribution transactions, tracking and documentation are critical. From a tax perspective, the partnership must maintain support for inside basis, outside basis, holding period, and any exceptions that could trigger gain, loss, or character recognition. From an audit and book perspective, the fund must separately support the fair value of the distributed asset under ASC 820, the impact to partners’ capital under ASC 946, and the related financial statement presentation.
- Track tax basis carefully: Maintain accurate records of both inside and outside basis to prevent unexpected taxable gains and to support the partner’s basis in distributed property.
- Document holding period treatment: Because the partner’s holding period often carries over from the partnership, support should be retained to determine whether future gain or loss is short-term or long-term.
- Evaluate tax exceptions: Consider whether cash or marketable securities exceed outside basis, whether hot assets are involved, or whether pre-contribution property rules apply.
- Measure the distribution at fair value for book purposes: For an ASC 946 investment company, the distributed investment should be measured at fair value under ASC 820 before it is removed from the schedule of investments.
- Record the book impact through partners’ capital: The fair value of the asset distributed should reduce net assets and the redeeming partner’s capital account. Any unrealized appreciation or depreciation through the distribution date should be reflected in operations.
- Assess financial statement presentation and disclosures: Confirm that the investment was removed from the schedule of investments, the distribution was properly reflected in partners’ capital, and disclosures sufficiently describe material in-kind distributions and valuation judgments.
- Coordinate with tax advisors: Given the complexity and the numerous exceptions in the rules, professional tax advice is strongly recommended for significant transactions.
In-kind distributions are a valuable tool for partnerships, providing flexibility and the potential for tax deferral. However, distinguishing between liquidating and non-liquidating distributions is crucial, as it determines the basis in distributed property and if and when gain or loss is recognized. Through careful planning and thorough documentation, partnerships can maximize the advantages of in-kind distributions while ensuring compliance with U.S. GAAP and tax regulations.
In-kind transactions run in both directions. If you are also weighing how appreciated assets move into a fund, read our companion piece on the tax implications of in-kind virtual currency contributions to hedge funds.
For specific guidance on your fund’s tax compliance, please reach out to your Richey May audit and tax professionals. To learn more about these best practices and how Richey May can help you navigate your filing obligations, contact Steve Vlasak, Business Development Partner, Alternative Investments Practice.
