Page 1 - Tax Treatment of Liquidations of Partnership Interests

COLUMNS | Tax Practice & Procedure

Tax Treatment of Liquidations

of Partnership Interests

By Eric Smith

he liquidation of a partner’s entire partnership interest IRC section 736 divides payments into two categories:
can take various forms, including payment made by the section 736(b) payments, which are taxed under the normal
Tpartnership to the retiring partner in complete redemp- partnership distribution rules, and section 736(a) payments,
tion of the partner’s interest or a sale of such interest to the which are treated either as part of the retiring partner’s
remaining partners. In both circumstances, the retiring partner distributive share of partnership income if determined with
receives cash or property in exchange for his partnership inter- respect to the income of the partnership, or as a guaranteed
est and the remaining partners proportionately increase their payment if determined without respect to the income of the
share in the assets of the partnership. Despite the economic partnership.
consequences of the sale and redemption being identical, the All liquidating payments to a retiring partner are treated as
structure can result in significantly different tax consequences IRC section 736(b) payments, with two exceptions. The first
to the retiring partner and the remaining partners. exception is for amounts paid to a retiring general partner
in a partnership in which capital is not a material income
Sale of a Partnership Interest producing factor (i.e., a service partnership) for 1) unreal-
The sale of a partnership interest is generally treated as ized receivables or 2) goodwill of the partnership (unless
a sale of a capital asset, resulting in capital gain or loss the partnership agreement expressly provides that a specific
for the selling partner. In order to prevent retiring partners portion of a redemption payment is attributable to goodwill).
the opportunity to convert ordinary income to capital gain, The second exception is amounts paid in excess of the value
however, IRC section 751 requires the selling partner to of the retiring partner’s interest, regardless of whether the
recognize ordinary income to the extent of any gain attrib- partner is a general partner or limited partner. Any payment
utable to IRC section 751 property (or “hot assets”). Hot that falls into one of the two exceptions is treated as a section
assets are defined to include unrealized receivables (e.g., 736(a) payment.
rights to payment under either goods or services contracts)
and inventory items. Only the excess, if any, of the purchase IRC Section 736(b) Payments
price over the amount characterized as ordinary income or Because IRC section 736(b) payments are taxed under the
loss is treated as capital gain. normal partnership distribution rules, the retiring partner will
If the partnership has an IRC section 754 election in recognize a capital gain or loss to the extent the amount of
effect, the purchasing partners will be entitled to a positive cash received is greater or less than the retiring partner’s
or negative basis adjustment in their respective share of the basis in his partnership interest. However, if the partnership
partnership’s assets attributable to the acquired interest. If assets include unrealized receivables or substantially appre-
the purchase price for the partnership interest will be paid ciated inventory items, a portion of the redemption payment
to the selling partner in more than one taxable year, the gain will be ordinary income attributable to the deemed sale of
or loss is recognized by the selling partner over the period in such assets by the partnership that would be allocable to the
which the payments are made under the installment method. retiring partner. This rule is narrower than the rule for hot
The installment method, however, is not available for gain assets described above on the sale of partnership interests
attributable to hot assets. that applies to all inventory items instead of substantially
appreciated inventory items.
Redemption of a Partnership Interest IRC section 736(b) payments are not deductible by the
Redemptions of a partner’s entire partnership interests are partnership and will not affect the basis of any partnership
governed by IRC section 736. That section does not affect assets unless the partnership has made an IRC section 754
the amount of income, gain, or loss that will be reported election or the partnership has unrealized receivables or
by the retiring partner; instead, it determines whether the substantially appreciated inventory items, in which case the
income will be a capital gain (or loss) or ordinary income, partnership receives a cost basis for the deemed purchase of
and whether the remaining partners will be able to deduct a such assets from the retiring partner. Section 736 payments
portion of the redemption payments. should not be subject to self-employment tax, nor should

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