‍In the world of business, owners often make critical decisions, and one such decision is to sell their partnership interests. This decision is influenced by several factors, but it is essential to consider federal, state, and local income tax implications to avoid higher taxes and reduced returns. This article explores the sale of partnership interests, offering strategies to maximize value and navigate tax complexities.

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KEY TAKEAWAYS

• The tax treatment of partnership assets depends on their classification as capital or ordinary income assets. Different tax rules apply to unrealized receivables or inventory.

• The Internal Revenue Code (IRC) Section 736 governs the redemption of an entire partnership interest, which determines the classification of income as either capital gain or loss, or ordinary income.

• Payments under IRC Section 736(a) can be classified as distributive shares of partnership income or guaranteed payments, while payments under IRC Section 736(b) are subject to standard partnership distribution rules.

• The sale of a partnership interest is treated as the sale of a capital asset, except for certain types of partnership assets that may require allocation of gain or loss based on different tax rates.

• When a partnership ends, the buyer is considered to have received a share of the assets that are attributable to their previous interest. As a result, they must recognize any gain or loss that arises from this distribution. The determination of the assets received in this deemed liquidation is done according to section 732(b).

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When a partner transfers their ownership stake in a partnership to another individual or entity, it is considered a sale of the partnership interest. It is essential to comprehend the tax implications involved in such transactions. In the case of a sale, the partner may be responsible for paying the capital gains tax, which is calculated based on the difference between the selling price and their adjusted basis in the partnership.

The tax treatment of gains or losses depends on the asset classification as capital or ordinary income. Different tax rules may apply for unrealized receivables or inventory held by the partnership.

Navigating the complexities of tax laws can be challenging for both buyers and sellers. Therefore, it is crucial for them to carefully consider the potential tax consequences before proceeding with any transaction. Seeking professional advice from tax specialists is highly recommended to ensure compliance with applicable tax laws and regulations. By doing so, parties involved can make informed decisions and mitigate any potential risks associated with tax liabilities.

Redemption of a partnership interest

When a partner's share in a partnership is redeemed, they may experience a gain or loss. This gain or loss is usually considered a capital gain or loss and is subject to specific rules and holding period requirements. The redemption of a partner's entire partnership interest is governed by IRC Section 736. This section does not impact the amount of income, gain, or loss that the retiring partner will report. Rather, it determines whether the income will be classified as capital gain or loss, or ordinary income and whether the remaining partners will be able to deduct a portion of the redemption payments.

IRC Section 736 classifies payments into two categories: Section 736(a) payments and Section 736(b) payments. Section 736(a) payments are either part of the retiring partner's distribution share of partnership income (if determined based on the income of the partnership) or a guaranteed payment (if determined independently of the partnership's income). Section 736(b) payments are subject to taxation based on the standard partnership distribution rules.

• IRC Section 736(a) Payments

IRC Section 736(a) payments can be classified as either a distributive share of partnership income or a guaranteed payment, depending on the type of partnership income received. If the partnership income is ordinary income, then the distributive share will be characterized as such. If the partnership income is capital gain, then the distributive share will be characterized as capital gain. The payment is not deductible for the remaining partners, but it will still reduce their share of partnership income. In contrast, guaranteed payments are considered ordinary income for the retiring partner and are deductible by the partnership. As a result, the remaining partners' share of partnership income will be reduced.

Payments considered guaranteed payments under IRC Section 736(a) are subject to self-employment tax. In addition, depending on the type of income that the payment can be attributed to, it may also be subject to the Medicare contribution tax. If the retiring partner and the partnership were involved in a trade or business, a section 736(a) payment that is treated as a distributive share of partnership income would be subject to self-employment tax.

• IRC Section 736(b) Payments

Payments made under IRC Section 736(b) are subject to taxation based on the standard partnership distribution rules. When a partner retires, they will recognize a capital gain or loss to the extent that the cash received exceeds or falls short of their basis in the partnership interest. However, if the partnership owns unrealized receivables or significantly appreciated inventory items, a part of the redemption payment will be considered ordinary income. This income is attributable to the partnership's deemed sale of those assets and is allocated to the retiring partner.

IRC Section 736(b) is not deductible for the partnership and does not affect the basis of any partnership assets unless the partnership has made an IRC Section 754 election or has unrealized receivables. In such cases, the partnership acquires a cost basis for the assets deemed purchased from the retiring partner. Payments made under Section 736 are not subject to self-employment tax, nor are they subject to the 3.8% Medicare contribution tax on net investment income.

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CHARACTER OF GAIN

Partnership taxation classifies the profit obtained from the sale of a partnership interest as a capital gain, which has lower tax rates. However, some assets, including inventory, depreciation recapture, and accounts receivable of a cash basis partnership, are subject to higher ordinary income tax rates.

If a sale involves the selling partner's portion of the assets, any profit or loss is subject to normal income tax rates. In the case of selling real estate, if the gain is due to depreciation deductions, it is referred to as "unrecaptured IRC §1250 gain." This type of gain is taxed at a fixed rate of 25%.

ISSUES IN SALE OF A PARTNERSHIP INTEREST

• The ownership interest of a partner in a partnership is a separate asset that can be sold.

• When a partner sells their partnership interest, any resulting gain or loss is treated as a capital asset sale.

• While the general rule is that partners are taxed on the gain or loss from the sale of their interest in a partnership, there is an exception to this rule for certain types of assets held by the partnership. The partnership's assets are considered as a whole, and the concept of "look-through" is applied. As a result, the partner may need to allocate a portion of the gain or loss from the sale of their interest, subject to different tax rates based on the types of assets owned by the partnership entity.

• There is an exception that applies to assets that are subject to unrecaptured section 1250 gain treatment. In such cases, the gain or loss must be allocated by the selling partners based on their share of the assets that fall under this category, specifically the IRC 1250 assets. Note that section 1250 has a higher tax rate than the capital gain tax rate.

• The fair market value of an asset can change over time. When a purchasing partner acquires a partnership interest at fair market value, there may be a difference between their outside basis in the partnership interest and their share of the partnership's inside basis in its assets. However, if the partnership decides to make a special basis adjustment, this difference can be reconciled.

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TERMINATION OF THE PARTNERSHIP

When a partnership is terminated, it is important to note that the buyer receives a distribution of assets that were previously part of their ownership in the partnership. As per section 731(a), the buyer must recognize any gain or loss resulting from this distribution of assets. The determination of the assets the buyer receives in the deemed liquidation of the partnership interest shall be carried out according to section 732(b).

Let us consider a hypothetical situation where two partners, John, and Mary, are involved. Mary decides to sell her partnership interest to John for $20,000. As per § 708(b)(1)(A), this purchase will terminate the partnership. In such a scenario, Mary should consider this transaction as a sale of her partnership interest and report any gain or loss according to § 741. The partnership is deemed to distribute all its assets to both Mary and John, based on McCauslen and Rev. Rul. 67-65. John's basis for the assets attributed to Mary's interest will be $20,000, and the holding period for these assets will start from the day after the sale (according to Rev. Rul. 66-7, 1966-1 C.B. 188).  

Let us consider a hypothetical situation where two partners, John, and Mary, are involved. Mary decides to sell her partnership interest to John for $20,000. As per § 708(b)(1)(A), this purchase will terminate the partnership. In such a scenario, Mary should consider this transaction as a sale of her partnership interest and report any gain or loss according to § 741. The partnership is deemed to distribute all its assets to both Mary and John, based on McCauslen and Rev. Rul. 67-65. John's basis for the assets attributed to Mary's interest will be $20,000, and the holding period for these assets will start from the day after the sale (according to Rev. Rul. 66-7, 1966-1 C.B. 188).

When a partnership is terminated, John will receive assets related to his former interest, and he will have to recognize gain or loss as required by § 731(a). John's basis in these assets will be determined under § 732(b). Moreover, John's holding period for his interest's assets will include the partnership's holding period under § 735(b), except for § 735(a)(2) purposes.

Let us look at another example with the same scenario but added debt and property.

CONCLUSION

Partnership interest sales and partner redemption can be challenging from a tax perspective. It is crucial for both buyers and sellers to understand the tax implications, including capital gains tax, ordinary income treatment, and potential income allocation based on partnership assets. Seeking professional tax advice is highly recommended to navigate these complexities, ensure tax law compliance, and mitigate potential risks associated with tax liabilities. In addition, when terminating a partnership, it is critical to carefully evaluate asset distributions and recognize gains or losses. By being aware of these intricacies and working with tax professionals, parties involved can make informed decisions and manage their tax obligations effectively regarding partnership transactions.

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