Tax Rules for a Transfer of Partnership Interest to a Partner

A transfer of a partnership interest between partners occurs when an existing partner sells their stake in the business to another individual, who may be a new or existing partner. While this sounds straightforward, the tax implications are governed by a unique and complex set of rules that differ from a simple asset sale.

The general principle under Internal Revenue Code Section 741 is that the gain or loss from the sale is a capital gain or loss. This treatment, however, is subject to significant exceptions based on the types of assets the partnership owns. The law employs a “look-through” concept in certain situations, which requires an analysis of the partnership’s underlying assets to determine the character of the gain. This approach prevents partners from converting what would otherwise be ordinary income into a more favorably taxed capital gain simply by selling their interest in the partnership entity.

Tax Consequences for the Selling Partner

The primary calculation for a selling partner is determining the gain or loss from the sale, which is the difference between the amount realized and their adjusted basis in the partnership interest. The “Amount Realized” is a comprehensive figure that includes not only the cash and fair market value of any property received but also the seller’s share of partnership liabilities that are assumed by the buyer. This inclusion of debt relief means a partner can have a taxable gain even if they receive little or no cash in the transaction.

A partner’s “Adjusted Basis” is their tax investment in the partnership. It begins with their initial contribution or purchase price and is adjusted over time. The basis increases with additional contributions and the partner’s share of partnership income. Conversely, it decreases due to distributions from the partnership and the partner’s share of any losses. These ongoing adjustments are mandated by Internal Revenue Code Section 705 to accurately reflect the partner’s investment at the time of sale.

A significant complication in this process arises from the “hot assets” rule under Internal Revenue Code Section 751. “Hot assets” are primarily defined as unrealized receivables and inventory items. Unrealized receivables include rights to payment for goods or services that the partnership has not yet recognized as income, while inventory includes any property held for sale to customers in the ordinary course of business.

When a partnership holds these assets, the selling partner must recharacterize a portion of their gain as ordinary income. The calculation requires the partnership to determine the amount of ordinary income that would have been allocated to the selling partner if the partnership had sold all its hot assets at fair market value right before the transfer. For example, if a partner realizes a total gain of $100,000, and their share of gain from hot assets is calculated to be $30,000, then $30,000 is reported as ordinary income and the remaining $70,000 is a capital gain.

Tax Consequences for the Acquiring Partner

For the partner purchasing the interest, the immediate tax consequence is the determination of their initial basis in the partnership. This figure, often called the “outside basis,” is foundational for all future tax calculations related to their ownership, including the determination of gain or loss on a future sale. The rules for this calculation are principally governed by Internal Revenue Code Section 742.

The acquiring partner’s basis is its cost. This cost includes the total amount paid for the interest, which encompasses any cash paid and the fair market value of any property transferred to the seller. A component of the initial basis is the acquiring partner’s share of the partnership’s liabilities that they assume as part of the transaction. This assumption of debt increases the buyer’s basis in the same way it increases the seller’s amount realized.

For instance, if a new partner pays $50,000 in cash for an interest and also assumes $20,000 of partnership liabilities previously allocated to the selling partner, the acquiring partner’s initial outside basis is $70,000.

Impact on the Partnership and the Section 754 Election

The sale of a partnership interest between partners does not automatically affect the partnership’s tax basis in its assets, known as the “inside basis.” This can create a disparity for the acquiring partner. Their “outside basis” reflects the fair market value they paid, while their share of the partnership’s “inside basis” is based on the partnership’s historical cost for its assets. This imbalance can cause the new partner to be taxed on gains that were economically realized by the selling partner.

To address this potential inequity, a partnership can make what is known as a Section 754 election. This election allows the partnership to adjust the inside basis of its assets, but only for the benefit of the acquiring partner. The adjustment, governed by Internal Revenue Code Section 743, is the difference between the transferee partner’s basis in their partnership interest and their proportionate share of the partnership’s basis in its property.

For example, if a new partner pays $100,000 for an interest and their share of the partnership’s inside basis in its assets is only $60,000, a Section 754 election would allow the partnership to increase the basis of its assets by $40,000, specifically for that new partner. This “step-up” in basis means the new partner will not have to recognize taxable gain on the first $40,000 of appreciation that was already present when they bought their interest.

Making a Section 754 election is a formal process; the partnership must attach a statement to its timely filed tax return for the year of the transfer. Once made, the election is binding for all future transfers and distributions and can only be revoked with IRS permission. While beneficial in many sales, the election creates an administrative burden, as the partnership must track these special basis adjustments. In some cases, such as when a partnership has a “substantial built-in loss” (meaning the property’s basis exceeds its fair market value by more than $250,000), a basis adjustment is mandatory.

Reporting the Transfer

The selling partner has the primary responsibility for reporting the gain or loss on their individual income tax return. The ordinary income portion of the gain is reported on Form 4797, Sales of Business Property. The remaining capital gain or loss is reported on Form 8949, Sales and Other Dispositions of Capital Assets. The totals from Form 8949 are then carried over to Schedule D (Form 1040). The selling partner is also required by Treasury Regulation 1.751-1 to attach a statement to their return detailing the sale date and the allocation of gain.

The partnership also has a reporting obligation. Once the partnership receives notice of a sale involving Section 751 assets, it must file Form 8308, Report of a Sale or Exchange of Certain Partnership Interests. This form is filed with the IRS and a copy is provided to both the selling and acquiring partners. The partnership’s annual tax return, Form 1065, will reflect the ownership change. The Schedules K-1 issued to the partners for the year of the sale will be adjusted, with the selling partner receiving a “final” K-1 that reports their share of partnership items up to the date of sale.