Sooner or later, your firm will encounter the issue of buying out a partner. This may be due to the partner’s retirement, death or other reasons. 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.
The Basic Tax Rules
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. This is also true of payments made by the partnership to liquidate the entire interest of a deceased partner’s successor in interest (usually the estate or surviving spouse).
Here’s what the tax code section says:
- Payments to liquidate the exiting partner’s interest can include a single payment or a series of payments that occur over a number of years.
- The same rules apply if your firm operates as a limited liability company (LLC), which is treated as a partnership for federal tax purposes.
- All payments to the exiting partner in liquidation of his entire interest are treated as either:
1. 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.
2. Section 736(b) payments, which are considered payments for the exiting partner’s share of the partnership’s assets. The partnership cannot deduct these payments. In general, the exiting partner treats the difference between the total Section 736(b) payments received, and his or her tax basis in the partnership interest, as a capital gain or loss.
Tax Opportunities And Pitfalls
The different tax treatments for Section 736(a) and Section 736(b) payments create tax planning opportunities, as well as potential tax pitfalls, for both the partnership and the exiting partner.
Clearly, the exiting partner and the remaining partners have competing interests. The partnership would prefer to maximize the amounts treated as Section 736(a) payments. Why? Because the partnership can deduct these payments, which results in tax savings for the remaining partners.
Conversely, the exiting partner would like to maximize the amount treated as Section 736(b) payments because they are generally treated first as a tax-free return of basis and then as low-taxed capital gain. The alternative Section 736(a) payments will result in high-taxed ordinary income.
Key Point: The Section 736 rules explained in this article only apply when the exiting partner receives payments directly from the partnership, and the remaining partners’ interests increase proportionately as a result. A different set of federal income tax rules applies when the remaining partners use their own money to buy out the exiting partner’s interest.
As you can see, liquidating payments to an exiting partner have important tax implications for both the continuing partnership and the recipient. Your tax advisor can help structure a payment program that achieves the desired tax results.