Partnership Redemption Tax Treatment and Rules

When a partner departs from a business, the financial separation can be structured in several ways. A partnership redemption occurs when the partnership entity itself buys out and liquidates a departing partner’s interest using the firm’s funds. This internal buyout is different from a cross-purchase agreement, where the remaining partners purchase the departing partner’s interest directly with their personal funds. While the economic result is similar, the tax treatment for all parties is significantly different under rules outlined in the Internal Revenue Code.

Tax Consequences for the Redeemed Partner

The tax outcome for a redeemed partner depends on the payments received versus their investment basis in the partnership. If cash distributions exceed the partner’s basis, the partner recognizes a capital gain. Conversely, if the basis is greater than the cash received, a capital loss is recognized.

A partner’s investment basis, or “outside basis,” begins with their initial capital contribution, including cash and the adjusted basis of any property contributed. The basis increases with additional capital contributions and the partner’s share of income and gains. It subsequently decreases with distributions received from the partnership and the partner’s share of any partnership losses.

However, not all payments are treated as a simple return of capital. The Internal Revenue Code requires that payments be classified, which determines whether a portion is taxed as a capital gain or as ordinary income. This distinction affects the after-tax proceeds, as ordinary income is taxed at higher rates and may be subject to self-employment tax.

Classifying Redemption Payments

The tax treatment of payments made to a retiring partner is governed by Internal Revenue Code Section 736, which separates payments into two categories. The allocation of payments between these categories is one of the most negotiated aspects of a partner’s exit.

Payments for Interest in Partnership Property

The first category, Section 736(b) payments, covers amounts paid for the redeemed partner’s interest in the partnership’s property. These payments are treated as distributions, allowing the partner to first recover their basis without tax consequences. Any cash received above the partner’s basis is treated as a capital gain, which is often preferred by the departing partner due to lower tax rates.

Partnership property includes most business assets, like cash, equipment, and real estate. However, the tax code excludes certain assets from this treatment. Payments for a partner’s share of the partnership’s “unrealized receivables” and “substantially appreciated inventory,” known as “hot assets” under Section 751, are not considered Section 736(b) payments.

Unrealized receivables include rights to payment for goods or services not yet included in the partnership’s income. Substantially appreciated inventory is inventory with a fair market value more than 120% of its adjusted basis. When a redemption payment is attributable to these hot assets, that portion is taxed as ordinary income.

Other Payments

Any payment not for a partner’s interest in qualifying partnership property falls under Section 736(a) and is treated as ordinary income to the redeemed partner. These payments are divided into two types: those determined with regard to partnership income and those determined without.

Payments determined with regard to partnership income are treated as a distributive share of that income. Payments determined without regard to partnership income are classified as guaranteed payments. In either case, the result for the departing partner is ordinary income, which may be subject to self-employment taxes.

A significant component of “other payments” often relates to goodwill. For most redemptions, including those of limited partners or partners in firms where capital is a material income-producing factor, payments for goodwill must be treated as Section 736(b) payments. This results in capital gain treatment for the departing partner and is not deductible by the partnership.

However, the tax code provides flexibility for a general partner leaving a service partnership where capital is not a material income-producing factor. In these cases, the partnership agreement dictates the outcome. If the agreement provides for a goodwill payment, it is a Section 736(b) payment; if the agreement is silent, the payment is classified under Section 736(a), becoming ordinary income to the partner and deductible by the partnership.

Tax Consequences for the Partnership and Remaining Partners

The tax consequences of a redemption for the partnership and its remaining members are a mirror image of those for the departing partner. This creates a dynamic where the financial interests of the departing partner and the ongoing partnership are often in direct opposition.

Payments classified under Section 736(a), which are ordinary income to the redeemed partner, provide a tax benefit to the partnership. If the payment is a guaranteed payment, the partnership can deduct the amount, reducing the taxable income allocated to the remaining partners. If the payment is a distributive share, it directly reduces the amount of income the remaining partners must report.

Conversely, payments classified under Section 736(b) for the partner’s interest in property offer no immediate benefit. These payments are not deductible by the partnership and are treated as a capital transaction. This is why remaining partners often prefer to allocate as much of the buyout as possible to Section 736(a) categories.

To address inequities from non-deductible Section 736(b) payments, partnerships can use a Section 754 election. With this election in effect, the partnership can adjust the tax basis of its internal assets, known as the “inside basis.” A Section 734 basis adjustment allows the partnership to increase its property basis by the amount of gain the departing partner recognized on the redemption.

This upward basis adjustment can be a significant benefit. If allocated to depreciable assets like buildings or goodwill, the partnership can claim higher depreciation or amortization deductions in future years. These deductions lower the partnership’s taxable income, reducing the tax liability for the remaining partners over time. A Section 754 election is a formal process filed with the partnership’s tax return for the year of the redemption and is generally irrevocable.

Reporting and Documentation Requirements

Meticulous documentation and accurate tax reporting are necessary to ensure the intended tax consequences of a redemption are respected by the IRS. The cornerstone of this process is the Redemption Agreement, which provides the definitive record of the negotiated terms.

The Redemption Agreement must clearly detail the total payment amount and, importantly, the allocation of these payments between Section 736(a) and Section 736(b) categories. This allocation is the primary evidence supporting the tax treatment claimed by both parties. If the parties agree to treat a payment for goodwill as a capital transaction, the agreement must explicitly state this.

The partnership reports the redemption on its annual tax return, Form 1065, U.S. Return of Partnership Income. The financial effects of the redemption, such as deductible guaranteed payments or changes to the balance sheet from property payments, are reflected throughout the return.

Finally, the partnership must provide a final Schedule K-1 to the departing partner for the year of the redemption. This form reports the partner’s share of the partnership’s items for their final period of ownership and must accurately reflect the character of the redemption payments. If a partner is redeemed through a series of payments, they are treated as a partner for tax purposes and receive a K-1 until the final payment is made.