The liquidation of a partner’s entire partnership interest can take various forms, including payment made by the partnership to the retiring partner in complete redemption of the partner’s interest or a sale of such interest to the remaining partners. In both circumstances, the retiring partner receives cash or property in exchange for his partnership interest and the remaining partners proportionately increase their share in the assets of the partnership. Despite the economic consequences of the sale and redemption being identical, the structure can result in significantly different tax consequences to the retiring partner and the remaining partners.

Sale of a Partnership Interest

The sale of a partnership interest is generally treated as a sale of a capital asset, resulting in capital gain or loss for the selling partner. In order to prevent retiring partners the opportunity to convert ordinary income to capital gain, however, IRC section 751 requires the selling partner to recognize ordinary income to the extent of any gain attributable to IRC section 751 property (or “hot assets”). Hot assets are defined to include unrealized receivables (e.g., rights to payment under either goods or services contracts) and inventory items. Only the excess, if any, of the purchase price over the amount characterized as ordinary income or loss is treated as capital gain.

If the partnership has an IRC section 754 election in effect, the purchasing partners will be entitled to a positive or negative basis adjustment in their respective share of the partnership’s assets attributable to the acquired interest. If the purchase price for the partnership interest will be paid to the selling partner in more than one taxable year, the gain or loss is recognized by the selling partner over the period in which the payments are made under the installment method. The installment method, however, is not available for gain attributable to hot assets.

Redemption of a Partnership Interest

Redemptions of a partner’s entire partnership interests are governed by IRC section 736. That section does not affect the amount of income, gain, or loss that will be reported by the retiring partner; instead, it determines whether the income will be a capital gain (or loss) or ordinary income, and whether the remaining partners will be able to deduct a portion of the redemption payments.

IRC section 736 divides payments into two categories: section 736(b) payments, which are taxed under the normal partnership distribution rules, and section 736(a) payments, which are treated either as part of the retiring partner’s distributive share of partnership income if determined with respect to the income of the partnership, or as a guaranteed payment if determined without respect to the income of the partnership.

All liquidating payments to a retiring partner are treated as IRC section 736(b) payments, with two exceptions. The first exception is for amounts paid to a retiring general partner in a partnership in which capital is not a material income producing factor (i.e., a service partnership) for 1) unrealized receivables or 2) goodwill of the partnership (unless the partnership agreement expressly provides that a specific portion of a redemption payment is attributable to goodwill). The second exception is amounts paid in excess of the value of the retiring partner’s interest, regardless of whether the partner is a general partner or limited partner. Any payment that falls into one of the two exceptions is treated as a section 736(a) payment.

IRC Section 736(b) Payments

Because IRC section 736(b) payments are taxed under the normal partnership distribution rules, the retiring partner will recognize a capital gain or loss to the extent the amount of cash received is greater or less than the retiring partner’s basis in his partnership interest. However, if the partnership assets include unrealized receivables or substantially appreciated inventory items, a portion of the redemption payment will be ordinary income attributable to the deemed sale of such assets by the partnership that would be allocable to the retiring partner. This rule is narrower than the rule for hot assets described above on the sale of partnership interests that applies to all inventory items instead of substantially appreciated inventory items.

IRC section 736(b) payments are not deductible by the partnership and will not affect the basis of any partnership assets unless the partnership has made an IRC section 754 election or the partnership has unrealized receivables or substantially appreciated inventory items, in which case the partnership receives a cost basis for the deemed purchase of such assets from the retiring partner. Section 736 payments should not be subject to self-employment tax, nor should they be subject to the 3.8% Medicare contribution tax on net investment income.

IRC Section 736(a) Payments

As described above, IRC section 736(a) payments will either be treated as a distributive share of partnership income or as a guaranteed payment. The character of the distributive share of partnership income will depend upon whether the underlying partnership income is ordinary income or capital gain. While this payment is not deductible to the remaining partners, it will reduce their share of partnership income. Guaranteed payments are treated as ordinary income to the retiring partner. Moreover, guaranteed payments are deductible by the partnership. Therefore, under either treatment, the remaining partners’ share of partnership income will be reduced.

IRC section 736(a) payments treated as guaranteed payments will be subject to self-employment tax and, depending on the type of income the guaranteed payment is attributable to, could be subject to the Medicare contribution tax. Section 736(a) payments treated as distributive share of partnership income will likely be subject to self-employment tax if the retiring partner is a general partner and the partnership was engaged in a trade or business. Such payments may also be subject to the Medicare contribution tax if the underlying partnership income qualifies as net investment income.

Redemptions Involving Deferred Payments

The tax treatment of the redemption of a partnership interest involving deferred payments is more advantageous to the retiring partner than the sale of the partnership interest. A retiring partner receiving redemption payments in more than one year is generally able to fully recover his basis before any gain is recognized. This advantageous tax treatment does not apply if the partnership assets include unrealized receivables or substantially appreciated inventory, in which case the retiring partner must recognize income attributable to such assets immediately as a result of the deemed asset sale by the partnership. By contrast, if the liquidation is structured as a sale of the retiring partner’s interest, purchase price payments made in multiple tax years will be subject to the installment method, which will require the retiring partner to recognize gain or loss with each installment payment.

Redemptions Involving Payments for Goodwill

Service partnerships from which a general partner is retiring have the option to treat redemption payments to such partner attributable to goodwill as either an IRC section 736(a) payment or a section 736(b) payment, depending on whether the partnership agreement specifically provides for goodwill payments. If the payment for goodwill is classified as a section 736(a) payment, it is ordinary income to the retiring partner and deductible by the remaining partners. On the other hand, if it is classified as a section 736(b) payment, it is a capital gain to the retiring partner and nondeductible to the remaining partners. This flexibility is not available if the liquidation is structured as a sale of the retiring partnership’s interest. In that case, payments attributable to the partnership’s goodwill would be treated as capital gain.