Sale of a Partnership Interest to Another Partner: Tax Rules

The sale of a partnership interest from one partner to another, often called a cross-purchase, involves one partner selling their ownership stake directly to another existing partner or a new incoming partner. While seemingly straightforward, the tax implications are multifaceted, affecting the seller, the buyer, and the partnership entity itself. The structure of this transaction dictates a specific set of tax consequences that differ significantly from other methods of exiting a partnership.

Tax Consequences for the Selling Partner

The primary tax event for the selling partner is the calculation of gain or loss. This process begins with determining the “amount realized,” which is the total value received for the interest. This figure includes cash, the fair market value of any property received, and the selling partner’s share of any partnership liabilities they are relieved of. This inclusion of liability relief can significantly increase the taxable gain without providing additional cash.

Once the amount realized is established, the seller subtracts their adjusted basis in the partnership interest to determine the total gain or loss. This “outside basis” generally starts with the partner’s initial capital contribution and is subsequently adjusted over the life of the partnership. It increases with additional contributions and the partner’s share of partnership income, and it decreases with distributions and the partner’s share of partnership losses.

A key aspect of the sale is determining the character of the gain or loss. While the sale of a partnership interest is generally treated as the sale of a capital asset under Internal Revenue Code (IRC) Section 741, a specific provision, IRC Section 751, requires a portion of the gain to be recharacterized as ordinary income. This recharacterization applies if the partnership holds “hot assets,” which are primarily unrealized receivables and inventory items.

Unrealized receivables include rights to payment for goods or services that have not yet been included in the partnership’s income. Inventory items are assets held for sale in the ordinary course of business. When a partner sells their interest, they must calculate the amount of gain that would be ordinary income if the partnership had sold its hot assets at fair market value.

Consider a partner who sells their interest for $50,000 in cash and is relieved of $10,000 in partnership liabilities, making the total amount realized $60,000. If their adjusted outside basis is $20,000, the total gain is $40,000. If an analysis shows that $15,000 of this gain is attributable to the partner’s share of hot assets, then $15,000 will be taxed as ordinary income. The remaining $25,000 of the gain is treated as a capital gain. The partnership must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests.

Tax Consequences for the Buying Partner

For the partner acquiring the interest, the immediate tax consequence is the determination of their initial basis in the partnership. This “outside basis” is the purchase price, which consists of the cash paid, the fair market value of any property transferred, and the share of partnership liabilities the buyer assumes.

A significant issue arises because the buying partner’s new, higher outside basis does not automatically translate to their share of the partnership’s basis in its underlying assets, known as “inside basis.” This creates a disparity. For example, if the buyer paid a premium for the partnership interest because the partnership’s assets have appreciated, their share of the partnership’s low historical basis in those assets will not reflect the price they paid. This can lead to the new partner being taxed on gains that economically accrued before they joined the partnership.

To resolve this inside-outside basis disparity, the partnership can make a Section 754 election. This election is made by the partnership on its tax return for the year of the sale and, once made, generally remains in effect for all future transfers. The election allows the buying partner to benefit from a special basis adjustment under IRC Section 743. This adjustment increases or decreases the buyer’s share of the inside basis of the partnership’s assets to align with their outside basis.

The benefit of this adjustment is that it is allocated among the partnership’s assets, including depreciable property, amortizable intangibles, and inventory. If the partnership owns an appreciated building, the adjustment would step up the buying partner’s share of the basis in that building. Consequently, the buying partner can claim larger depreciation deductions than the other partners, reflecting their higher investment cost. This provides a direct tax benefit by reducing their share of taxable income in future years.

Impact on the Partnership

The sale of an interest between partners has a relatively minimal direct impact on the partnership entity. The partnership does not terminate for tax purposes, regardless of the percentage of interest sold. Under current law, the technical termination rules, which previously could dissolve a partnership for tax purposes if 50% or more of its interests were sold within a 12-month period, have been repealed for tax years beginning after 2017.

The partnership’s primary role in a cross-purchase transaction arises if a Section 754 election is made or is already in effect. If the election is made, the partnership assumes the administrative responsibility of tracking the special basis adjustments for the buying partner.

This involves calculating the adjustment and allocating it among its various assets according to specific regulations. In subsequent years, the partnership must account for this adjustment when calculating the buying partner’s share of income, gain, loss, and deductions, such as reporting the unique depreciation amount for the buying partner on their Schedule K-1.

Alternative Transaction Structure: Redemption

An alternative to one partner selling their interest to another is a redemption, also known as a liquidation of a partner’s interest. In a redemption, the transaction is between the departing partner and the partnership itself. The partnership, rather than another partner, buys out the departing partner’s entire interest, typically using partnership funds or assets.

The tax treatment for the departing partner in a redemption can be more complex than in a sale. Payments from the partnership are allocated between different categories, which can alter the character and timing of income recognition. Payments made in exchange for the partner’s interest in partnership property are generally treated as a distribution, resulting in capital gain or loss.

However, payments for the partner’s share of unrealized receivables and, in some cases, goodwill can be treated as guaranteed payments or a distributive share of partnership income, which are taxed as ordinary income. For the remaining partners, a redemption increases their proportional ownership interests in the partnership.

The basis treatment for the remaining partners also differs. Instead of getting a stepped-up basis in the partnership assets through a basis adjustment, the partnership may be able to step up the basis of its own assets under different rules (IRC Section 734) if a Section 754 election is in place.