When you enter into or form a partnership, it is important to keep careful records of each partner's contributions to the partnership. Contributions can be in cash, property or in the form of time and effort. The partnership should operate according to an established set of rules and bylaws, agreed in writing by each partner, with specific criteria and procedures for valuing a partner's interest if he should wish to withdraw some or all of his capital from the partnership.
The accounting staff or partnership management should carefully track the amounts of capital contributed by each partner and credit this amount to the partner's capital account. This record includes the initial "buy in," plus any additional infusions of capital subsequent to entering the partnership. Partners may also build up their capital accounts through "sweat equity," meaning in lieu of payment for their time working in the partnership. This contribution is distinct from a salary, however, as a salary or hourly wage does not equate to an equity interest in the partnership.
Occasionally, the partnership may distribute cash or other property back to the owners. This can be part of an equal and planned distribution to each partner, or can be due to the request of a partner who wishes to reduce or eliminate his interest in the partnership. Any distributions, whether of cash or property, should be recorded in that partner's capital account, until that capital account reaches zero.
As the business grows, so should a partner's capital account in the business. It can be very difficult to put a fair market value on some items -- such as goodwill, intangibles, unsold inventory of uncertain value -- or machinery or other capital equipment that has undergone depreciation. For this reason, an orderly and clearly defined set of rules governing any withdrawals of capital should be developed well ahead of time.
Taxation of Distributions
Generally, withdrawals from a partnership are taxed at favorable capital gains tax rates. The receiver pays taxes on the difference between his basis, which is the amount of his contributions, less prior distributions and pro rata share of deductions for depreciation of capital and equipment. However, if the Internal Revenue Service suspects that the partnership is conducting a disguised sale of inventory, and using the partnership distribution rules to avoid paying income tax on the sale, it may disallow the transaction.