Dear Tax Talk,
I am an operating partner for a chain restaurant here in Houston. I opened the new restaurant two years ago and paid $25,000 to become a partner in the restaurant. I am currently in the process of selling my partnership back to the corporation. How is distribution handled in terms of income and taxes? Is there anything I could do with the distribution that would limit my tax liability? 
— Scott

Dear Scott,
When you invest in a partnership, the partnership maintains a capital account for your investment. Your individual capital account is reflected on Schedule K-1, which the partnership furnishes to all the partners for tax reporting purposes. 

Your capital account includes your initial investment and changes that occur during the period of ownership. Your capital account is increased for income that you recognize and decreased for losses that you sustain. It is also increased for additional investments and decreased for withdrawals. 

In the year you sell your investment, these changes are calculated through the date of sale. For example, you will be allocated a percentage of the restaurant’s income up to the date of sale.

Usually your sale of a partnership investment results in capital gain or loss, measured by the difference in your capital account and the amount that you receive in liquidation. You can estimate that amount by looking at your ending capital account for 2007 and comparing it to the amount you will receive.

If you anticipate income for 2008, you may want to insist on additional operating distributions to offset the tax effects. Usually the partnership agreement specifies how distributions for payment of taxes are handled. In addition, certain underlying assets of the partnership may result in you recognizing ordinary income on the sale, but in a restaurant this should be minimal. 

A partnership interest does not qualify for like-kind exchange. Hence, you cannot avoid tax by reinvesting in another restaurant. If you anticipate a capital gain on the sale, you can offset the gain with other capital losses that you may have, such as from the sale of stock investments that have declined in value from their original cost.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.