Is Sale of Partnership Interest Reported on a K-1?

When a partner sells their interest in a partnership, the IRS requires detailed tax reporting to ensure proper taxation of any gains or losses. Schedule K-1 plays a key role in this process, reporting each partner’s share of income, deductions, and financial details. Proper handling of these tax implications helps prevent errors that could lead to penalties or IRS scrutiny.

Reporting the Transaction on the K-1

When a partner exits, the partnership must report their final allocations on Schedule K-1, including income, deductions, and credits up to the sale date. While the partnership itself does not recognize a gain or loss from the sale, it must disclose relevant details for tax purposes.

Box 19 of the K-1 reports distributions, including payments to the departing partner. If the sale involves a liquidating distribution, this box reflects the amount received. Box 20 may include details about Section 751 assets, such as unrealized receivables or inventory, which are taxed as ordinary income rather than capital gains.

In some cases, the K-1 includes footnotes or attachments for clarification, especially when the transaction involves complex allocations or a Section 754 election. A Section 754 election allows the partnership to adjust the basis of its assets to reflect the new ownership structure, which can impact depreciation and future gain recognition. These disclosures ensure both the seller and remaining partners have the necessary information for accurate tax filings.

Determining the Gain or Loss

The taxable gain or loss from selling a partnership interest is determined by comparing the amount received to the partner’s adjusted basis, which includes initial contributions, additional capital invested, and the partner’s share of income and deductions. Debt allocations also affect basis—an increase in a partner’s share of liabilities raises basis, while a decrease lowers it.

The character of the gain or loss depends on the partnership’s assets. Under IRC Section 741, the sale of a partnership interest generally results in capital gain or loss. However, if the partnership holds unrealized receivables or inventory classified as “hot assets” under IRC Section 751, part of the gain is treated as ordinary income. This matters because ordinary income is taxed at higher rates than long-term capital gains, which in 2024 are subject to a maximum federal rate of 20%, plus a potential 3.8% net investment income tax.

The holding period of the partnership interest also affects taxation. If held for more than one year, any capital gain is typically long-term. However, if portions of the interest were acquired at different times, part of the gain may be short-term and taxed at ordinary income rates of up to 37% in 2024.

Partner Capital Account Adjustments

When a partner exits, their capital account must be updated to reflect the transaction. The capital account represents the partner’s equity in the business and is adjusted to remove their share of the partnership’s equity for accurate tax and financial reporting.

If a Section 754 election is in effect, the partnership may adjust the basis of its assets to align with the transaction price. This adjustment prevents disparities in future depreciation and gain recognition, especially when asset values differ significantly from their book value.

The structure of the sale also affects tax treatment. If structured as a redemption rather than a direct sale to another partner, the tax consequences differ. In some cases, guaranteed payments may be required to compensate the departing partner for unrealized income or contractual obligations, impacting both the capital account and the partnership’s tax deductions.