Tax Consequences of Transfer of Partnership Interest

A partnership interest is a partner’s ownership stake in a business, including rights to profits, losses, and distributions. A transfer of this interest can occur through a sale, a gift, or an inheritance. Each method triggers unique tax consequences for the transferring partner, the new partner, and the partnership itself.

These tax rules affect the amount and character of any gain or loss and establish the new partner’s tax basis. The specific outcomes depend on the nature of the transfer and the partnership’s assets.

Tax Consequences for the Selling Partner

When a partner sells their interest, the primary tax consequence is the calculation of a gain or loss. This is determined by subtracting the partner’s adjusted basis in the partnership from the amount realized from the sale. The result dictates the taxable income or deductible loss the selling partner must report.

The amount realized is the total value received, including cash, the fair market value of any property, and the selling partner’s share of partnership liabilities. When a partner sells their interest, they are relieved of their portion of the partnership’s debts, and this relief is treated as additional cash received. For example, if a partner sells their interest for $50,000 cash and is also relieved of $20,000 in partnership liabilities, their total amount realized is $70,000.

A partner’s adjusted basis, often called “outside basis,” is their investment in the partnership for tax purposes. It begins with the initial contribution and increases with additional contributions and the partner’s share of partnership income. Conversely, it decreases with distributions from the partnership and the partner’s share of partnership losses. A partner’s share of liabilities also increases their outside basis.

The gain or loss from selling a partnership interest is a capital gain or loss, as the interest itself is a capital asset. However, an exception under Internal Revenue Code Section 751 can recharacterize a portion of this gain as ordinary income. This rule applies when the partnership holds “hot assets.”

Hot assets are property that would generate ordinary income if sold directly by the partnership, falling into two main categories: unrealized receivables and inventory items. Unrealized receivables are rights to payment for goods or services not yet included in income. Inventory items are broadly defined as any property held for sale in the ordinary course of business.

When a partnership holds hot assets, the selling partner must determine how much ordinary income they would have been allocated if the partnership had sold all its hot assets at fair market value. This amount is reported as ordinary income by the selling partner. The remaining gain from the sale is treated as a capital gain, which prevents converting ordinary income into more favorably taxed capital gains.

Tax Consequences for the Purchasing Partner

For the individual acquiring a partnership interest, the primary tax consideration is establishing their initial basis. This “outside basis” is used to determine the tax consequences of future distributions and any eventual sale of their own interest. The purchasing partner’s initial outside basis is their cost to acquire the interest, including cash paid, the fair market value of any property transferred, and acquisition costs. This basis is also increased by the new partner’s share of the partnership’s liabilities, as assuming these debts is treated as a cash contribution.

This outside basis is calculated independently of the partnership’s own basis in its underlying assets, known as the “inside basis.” A new partner’s outside basis reflects their purchase price, while the inside basis generally remains unchanged by the transfer, creating a potential disparity. For example, if a new partner pays $100,000 for an interest and assumes $20,000 of liabilities, their initial outside basis is $120,000. This amount serves as their starting point for all future basis adjustments.

The Section 754 Election and Basis Adjustments

A transfer of a partnership interest can create a mismatch between the new partner’s outside basis and their share of the partnership’s inside basis. The outside basis reflects the purchase price, while the inside basis is the partnership’s historical cost for its assets. To resolve this imbalance, a partnership can make a Section 754 election.

This election is made by the partnership, not an individual partner, and is filed with the partnership’s tax return for the year the transfer occurred. Once made, the election is binding for that year and all future years unless the IRS consents to a revocation. The election’s purpose is to adjust the basis of partnership property under Internal Revenue Code Section 743, aligning the new partner’s share of the inside basis with their outside basis.

This adjustment is personal to the purchasing partner and does not affect the other partners. It is calculated as the difference between the new partner’s outside basis and their proportionate share of the partnership’s inside basis. If the purchase price exceeds the new partner’s share of the inside basis, the adjustment is positive; if less, it is negative.

A positive adjustment provides a direct benefit to the new partner. For example, if the adjustment is allocated to depreciable property, the new partner is entitled to additional depreciation deductions. If the partnership later sells an asset with a positive adjustment, the new partner’s taxable gain is reduced. This effectively gives the new partner a cost basis in their share of the partnership’s assets, as if they had purchased those assets directly.

Transfers by Gift or Inheritance

The tax rules for acquiring a partnership interest through a gift or inheritance differ from those governing a purchase. These non-sale transfers have unique basis rules that impact the recipient’s future tax liability, depending on the method of transfer.

Transfer by Gift

When a partnership interest is transferred as a gift, the recipient generally takes a carryover basis. This means the donee’s basis is the same as the donor’s adjusted basis at the time of the gift, ensuring any appreciation remains subject to taxation upon a later sale. An exception arises if the donor’s share of partnership liabilities exceeds their adjusted basis. In this scenario, the transfer is treated as a partial sale, and the donor must recognize a gain on the excess amount. Gift tax may apply if the gift’s value exceeds the annual exclusion amount, which is $19,000 for 2025.

Transfer by Inheritance

A transfer of a partnership interest at death is treated differently, as the heir receives a “stepped-up” basis. The heir’s basis is adjusted to the interest’s fair market value at the date of the decedent’s death. This rule eliminates the capital gains tax on any appreciation that occurred during the decedent’s lifetime. For example, if a partner had an adjusted basis of $50,000 in an interest worth $200,000 at death, the heir’s basis becomes $200,000. If the heir immediately sells the interest for that price, they would recognize no taxable gain.