The federal income tax rules for partnership payments to buy out an exiting partner’s interest are tricky, but they also open up tax planning opportunities. Payments made by a partnership to liquidate (or buy out) an exiting partner’s entire interest are covered by Section 736 of the Internal Revenue Code.
How to buy out a partner interest in a partnership?
1 Purchase of a Partner's Interest. Under the purchase scenario, one or more remaining partners may buy out the terminating partner's interest for fair market value (FMV) plus any relief of ... 2 Liquidation of Partner's Interest. ... 3 Hot Assets. ... 4 Conclusion. ...
How does a change of partners affect the tax treatment?
Whether due to disagreements among the partners, the death or divorce of a partner, or the addition of new partners, these transactions can result in a discrepancy between a property’s fair market value (FMV) and its basis, which can ultimately affect the tax treatment of each partner’s reported income, gains and losses.
What are the tax consequences of selling a partnership interest?
Despite the economic consequences of the sale and redemption being identical, the structure can result in significantly different tax consequences to the retiring partner and the remaining partners. The sale of a partnership interest is generally treated as a sale of a capital asset, resulting in capital gain or loss for the selling partner.
Are guaranteed payments to exiting partners tax deductible?
Section 736 (a) payments, which are considered guaranteed payments to the exiting partner. The partnership is allowed to deduct these payments, which means tax savings for the remaining partners. However, the exiting partner must treat guaranteed payments as high-taxed ordinary income.
What are the tax implications of a partner buyout?
The tax basis for the departing partner's payment is the sum of their initial investment, any additional capital contributions made during their tenure as a partner, and their share of business income during that time, all reduced by their percentage of any business losses and distributions.
What happens when a partnership buys out a partner?
A sale of a partnership interest occurs when one partner sells their ownership interest to another person or entity. The partnership is generally not involved in the transaction. However, the buyer and seller will notify the partnership of the transaction.
Are buyout payments taxable?
Buyouts are included as an item of gross income and are considered as fully taxable income under IRS tax laws. Section 451(a) of the Internal Revenue Code provides that the amount of any item of gross income must be included in the gross income for the taxable year in which it is received by the taxpayer.
What are the tax consequences of selling a partnership interest?
Because tax law views a partnership both as an entity and as an aggregate of partners, the sale of a partnership interest may result either in a capital gain or loss or all or a portion of the gain may be taxed as ordinary income.
Is partner buyout an expense?
The firm buys out the retiring partner and his/her retirement payments are paid directly by the firm. The remaining partners “pay” for the buyout payments by treating these payments as an expense of the firm.
Is a transfer of partnership interest taxable?
In general, as noted earlier, the transferee of a partnership interest must withhold a tax equal to 10% of the amount realized by the transferor on any transfer of a partnership interest unless an applicable exception applies (as discussed below).
Is a partnership buy in tax deductible?
A distributive share entitlement is the partner's share of the partnership income and is taxed as ordinary income and deductible to the partnership. IRC 736(a) payments are deductible by the partnership, even if such payments may properly be considered attributable to unstated goodwill or similar intangibles.
How do you treat sale of partnership interest?
The sale of a partnership interest is generally treated as the sale of a capital asset. As a result, the sale of a partnership interest will generally generate capital gain or loss for the difference between the amount realized on the sale and the partner's adjusted basis in the partnership interest.
How do you report sale of partnership?
Partnerships file Form 8308 to report the sale or exchange by a partner of all or part of a partnership interest where any money or other property received in exchange for the interest is attributable to unrealized receivables or inventory items (that is, where there has been a section 751(a) exchange).
What happens to a partnership when ownership changes?
Having a partnership change in ownership can mean adding or withdrawing partners. Partners can agree to add new partners in two different ways. The partner who's new could buy out part or all of the interest of the current partner or partners.
What is liquidation of partner's interest?
Liquidation of Partner's Interest. The second method this item will discuss is where the partnership liquidates the terminating partner's interest. The partnership may use its assets to liquidate the partner's interest, or it can take on debt to liquidate the partner's interest. The remaining partners cannot fund the liquidation, ...
Does a liquidating partner receive a K-1?
The liquidating partner will no longer receive profit and loss allocations of the partnership after the date of termination; however, the partner will still receive a K-1 each year until the final payment is made.
Can a terminating partner sell his or her interest?
A terminating partner may sell his or her interest to one or more of the remaining partners, or the partnership may liquidate his or her interest. The tax issues associated with these two methods, such as whether the change generates ordinary income or ordinary deductions or capital gain treatment for the partnership and for ...
Is a 736 payment deductible?
Sec. 736 (a) payments are deductible by the partnership and are ordinary income to the liquidating partner, subject to self-employment tax. A cash-basis partner should be aware that if the partnership accrues a payment to the partner in its tax year, the partner must recognize that income in the same tax year.
When is a partnership required to adjust the basis of its assets?
The partnership will be required to adjust the basis of its assets when an interest in the partnership is transferred if the total adjusted basis of the partnership’s assets is greater than the total fair market value of the partnership’s assets by more than $250,000 at the time of the transfer.
What happens when a partnership is transferred?
A transfer of a partnership interest could result in an actual or technical termination of the partnership. The partnership will terminate on the date of transfer if there is one tax owner left after the transfer.
Can a partnership use the cash method?
Generally, a partnership may not use the cash method of accounting if it has a C corporation as a partner. Therefore, a transfer of a partnership interest to a C corporation could result in the partnership being required to change from the cash method to the accrual method. As described in this article, a transfer of a partnership interest involves ...
Can a partnership change its tax year?
Change in Tax Year of the Partnership. The transfer could result in a mandatory change in the partnership’s tax year. A partnership’s tax year is determined by reference to its partners. A partnership may not have a taxable year other than:
What is the tax treatment of a redemption of a partnership interest?
The tax treatment of the redemption of a partnership interest involving deferred payments is more advantageous to the retiring partner than the sale of the partnership interest. A retiring partner receiving redemption payments in more than one year is generally able to fully recover his basis before any gain is recognized. This advantageous tax treatment does not apply if the partnership assets include unrealized receivables or substantially appreciated inventory, in which case the retiring partner must recognize income attributable to such assets immediately as a result of the deemed asset sale by the partnership. By contrast, if the liquidation is structured as a sale of the retiring partner’s interest, purchase price payments made in multiple tax years will be subject to the installment method, which will require the retiring partner to recognize gain or loss with each installment payment.
What happens to a partner's entire partnership interest?
The liquidation of a partner’s entire partnership interest can take various forms, including payment made by the partnership to the retiring partner in complete redemption of the partner’s interest or a sale of such interest to the remaining partners. In both circumstances, the retiring partner receives cash or property in exchange ...
Is a 736 payment deductible?
While this payment is not deductible to the remaining partners, it will reduce their share of partnership income. Guaranteed payments are treated as ordinary income to the retiring partner. Moreover, guaranteed payments are deductible by the partnership. Therefore, under either treatment, the remaining partners’ share of partnership income will be reduced.
Does a 736B payment count as capital gain?
Because IRC section 736 (b) payments are taxed under the normal partnership distribution rules, the retiring partner will recognize a capital gain or loss to the extent the amount of cash received is greater or less than the retiring partner’s basis in his partnership interest. However, if the partnership assets include unrealized receivables or substantially appreciated inventory items, a portion of the redemption payment will be ordinary income attributable to the deemed sale of such assets by the partnership that would be allocable to the retiring partner. This rule is narrower than the rule for hot assets described above on the sale of partnership interests that applies to all inventory items instead of substantially appreciated inventory items.
Is a guaranteed payment deductible?
Guaranteed payments are treated as ordinary income to the retiring partner. Moreover, guaranteed payments are deductible by the partnership. Therefore, under either treatment, the remaining partners’ share of partnership income will be ...
Is a sale of a partnership a capital asset?
The sale of a partnership interest is generally treated as a sale of a capital asset, resulting in capital gain or loss for the selling partner. In order to prevent retiring partners the opportunity to convert ordinary income to capital gain, however, IRC section 751 requires the selling partner to recognize ordinary income to the extent ...
Is goodwill deductible?
If the payment for goodwill is classified as a section 736 (a) payment, it is ordinary income to the retiring partner and deductible by the remaining partners. On the other hand, if it is classified as a section 736 (b) payment, it is a capital gain to the retiring partner and nondeductible to the remaining partners.
What should be included in a partnership book after a partner dies?
Upon the partner's death, the partnership books should reflect the elimination of the deceased partner's interest in capital and the establishment of a payable to the partner's successor in interest. All subsequent payments made to retire the interest should reduce the payable ; Partnership returns should be filed as long as payments are being made ...
When can a business cease to be a partnership?
A business can also cease to be a partnership if its assets are transferred to a trust or the business is incorporated. Termination of two-partner partnership at one partner's death or retirement. Two - person partnerships necessitate careful planning to avoid inadvertent terminations.
When does a partnership terminate?
October 1, 2019. A partnership terminates under Sec. 708 (b) (1) when the business of the partnership is no longer carried on in partnership form. This can occur because the partnership elects out of partnership status, incorporates, or has only one partner remaining (for example, as the result of a sale or the death of a partner).
Can a deceased partner's interest be paid to a partnership?
All payments for the deceased partner's interest in the partnership should be made from the business account of the partnership and not from the personal account of the remaining partner. In some circumstances, it may not be desirable for the partnership to continue after a partners' death or retirement.
Is a business a partnership?
After the sale of the interests, the business is no longer carried on in a partnership form but rather is conducted as a proprietorship or branch (if the owner is a corporation, another partnership, or a multimember limited liability company (LLC)). A business can also cease to be a partnership if its assets are transferred to a trust or ...
What happens when an entity buys an interest in a partnership?
When an entity or person buys an interest in a partnership with appreciated assets, its “outside basis” in the property increases to the purchase price. Subsequently, the entity or person may reduce or even eliminate taxable gains at the partnership level when it sells the property in the future.
What is a 754 election?
To remedy this, a partnership may make a 754 election under Internal Revenue Code sections 743 (b) and 734 (b) to equalize the buyer’s basis in the purchased partnership interest in property (outside basis) and the buyer’s share of the basis of the assets inside the partnership net of liabilities (inside basis).
Purchase of A Partner's Interest
- The Sec. 754 election must be applied to each asset of the partnership. The difference between the FMV and the tax basis of each asset determines whether the asset will receive a step-up or a stepdown. If the partnership elects Sec. 754 treatment, any assets that have declined in value must be stepped down, just as the appreciated assets will be st...
Liquidation of Partner's Interest
- All payments to a partner in liquidation are treated as either Sec. 736(a) or Sec. 736(b) payments. Sec. 736(a) payments are for a continuing share of partnership income or for guaranteed payments. Sec. 736(a) payments also include payments for unrealized receivables and for goodwill when goodwill payments are not called for in the partnership agreement. This treatmen…
Hot Assets
- Note that if the sale is treated as an installment sale, the ordinary income due to the sale of hot assets will have to be recognized at the time of the sale and will not be allowed installment sale treatment (CCA 200722027). A further discussion of hot assets is beyond the scope of this item, but be aware that there are reporting obligations related to hot assets.
Conclusion
- Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY. Unless otherwise noted, contributors are members of or associated with DFK International/USA. For additional information about these items, contact Mr. Aponte at (212) 792-4813 or [email protected].