Page 2 - Tax Treatment of Liquidations of Partnership Interests

they be subject to the 3.8% Medicare contribution tax on goodwill payments. If the payment for goodwill is classified
net investment income. as a section 736(a) payment, it is ordinary income to the
retiring partner and deductible by the remaining partners. On
IRC Section 736(a) Payments the other hand, if it is classified as a section 736(b) payment,
As described above, IRC section 736(a) payments will it is a capital gain to the retiring partner and nondeductible to
either be treated as a distributive share of partnership income the remaining partners. This flexibility is not available if the
or as a guaranteed payment. The character of the distributive liquidation is structured as a sale of the retiring partnership’s
share of partnership income will depend upon whether the interest. In that case, payments attributable to the partner-
underlying partnership income is ordinary income or capital ship’s goodwill would be treated as capital gain.
gain. 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.
IRC section 736(a) payments treated as guaranteed
payments will be subject to self-employment tax and,
depending on the type of income the guaranteed pay-
ment is attributable to, could be subject to the Medicare
contribution tax. Section 736(a) payments treated as
distributive share of partnership income will likely be
subject to self-employment tax if the retiring partner is
a general partner and the partnership was engaged in
a trade or business. Such payments may also be sub-
ject to the Medicare contribution tax if the underlying
partnership income qualifies as net investment income.

Redemptions Involving Deferred Payments
The tax treatment of the redemption of a partnership
interest involving deferred payments is more advanta-
geous to the retiring partner than the sale of the part-
nership 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 Understanding the Consequences
retiring partner must recognize income attributable to such The tax consequences to the retiring partner and the
assets immediately as a result of the deemed asset sale by the remaining partners on the liquidation of the partner’s
partnership. By contrast, if the liquidation is structured as a interest can vary significantly, depending upon whether
sale of the retiring partner’s interest, purchase price payments the liquidation is structured as a sale or redemption. In
made in multiple tax years will be subject to the installment addition to understanding the structure of the transaction,
method, which will require the retiring partner to recognize CPAs faced with partners liquidating their entire interest
gain or loss with each installment payment. in a partnership will also need to consider whether any of
the partnership’s assets qualify as hot assets, whether the
Redemptions Involving Payments for Goodwill payments will be made over more than one taxable year,
Service partnerships from which a general partner is retir- and whether any portion of the payments is attributable
ing have the option to treat redemption payments to such to the partnership’s goodwill. ■
partner attributable to goodwill as either an IRC section
736(a) payment or a section 736(b) payment, depending on Eric Smith, JD/LLM, is counsel at Kostelanetz & Fink, LLP,
whether the partnership agreement specifically provides for New York, N.Y.

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