A partner receives a liquidating distribution consisting of $10,000 cash and inventory (Basis $5,000, FMV $8,000). The partner's outside basis was $20,000. What is the tax consequence?

Answer options:

No gain or loss; Inventory basis is $10,000.

$5,000 Capital Loss; Inventory basis is $5,000.

$5,000 Capital Gain.

No gain or loss; Inventory basis is $15,000.

How to approach this question

Liquidating Distribution Rules: 1. Reduce basis by cash ($20k - $10k = $10k). 2. Assign basis to hot assets (Inventory) equal to partnership basis ($5k). Cannot step up inventory. 3. Remaining basis ($5k) is a Capital Loss if no other assets received.

Full Answer

B.$5,000 Capital Loss; Inventory basis is $5,000.✓ Correct

IRC §731(a)(2). Loss is recognized if only money and unrealized receivables/inventory are received and their basis is less than the partner's outside basis. Outside ($20k) - Cash ($10k) - Inventory Basis ($5k) = $5,000 Loss.

Common mistakes

Stepping up the basis of inventory to absorb the excess outside basis.

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