When a partner leaves a business, the resulting transaction can take the form of a payment to the retiring partner to redeem his or her share of the business, or a sale of that share of the business to the remaining partners. Either way, the person who leaves obtains cash or property while the partners who remain increase their share of the assets on a proportional basis. While the end result appears to be the same, however, the tax implications can be quite disparate.
When the retiring partner receives a redemption payment, Section 736 of the Internal Revenue Code comes into play, determining firstly whether the income will be treated as a capital gain/loss or ordinary income, and secondly whether the remaining partners can deduct a percentage of their redemption payments.
There are two possibilities for how this plays out. Most liquidating payments to retiring partners fall under IRC Section 736(b), which means the retiring partner has a capital gain or loss depending on how the cash they receive compares with their basis in the partnership interest. These payments are not deductible by the partnership.
But there are two exceptions to this, which fall under IRC Section 736(a), either regarding a partnership where capital is not a material factor in producing income (for example, it revolves around service), or where the amount paid exceeds the value of the retiring partner’s interest. These payments are treated either as a distributive share of partnership income, which reduces the share of—and is not deductible for—the remaining partnership. Guaranteed payments become ordinary income for the retiring partner and are deductible by the partnership.
When the transaction is treated as a sale rather than a redemption, this amounts to the sale of a capital asset. This results in a capital gain/loss for the selling partner, but IRC Section 751 prevents them from converting ordinary income to capital gains when the transaction includes “hot assets” such as unrealized receivables and inventory items. Capital gains can only result from the purchase price being higher than the amount characterized as ordinary income or loss.
The purchasing partners will be able to receive a positive or negative basis adjustment in their respective shares of the partnership assets linked to the acquired interest when the partnership has an IR
C Section 754 election in effect. When the selling partner will receive their payments over the course of more than one taxable year, that gain or loss is recognized for the entire period of installments, unless those gains are attribute to hot assets, in which case that method cannot be used.
While the liquidation of one partner’s interest in a business is in many ways identical whether it’s structured as a sale or redemption, the tax consequences to both the partner who’s leaving the company and those who remain can be quite different, and it’s important to understand these differences before signing off on the transaction.