The withdrawal of a partner from a partnership is one of the most common business transactions. In some cases, the partner leaves amicably; in other cases, the departure may occur after many disagreements and, perhaps, litigation.  Regardless of the cause of the partner’s withdrawal, it is often the case that neither the partner nor the continuing partnership has thoroughly considered the income tax consequences of the withdrawal.  As a result, the economic cost of the separation may be greater than need be.

Liquidation:  Timing

As a matter of state law, the withdrawal or “retirement” of a partner from a partnership occurs when the partnership redeems the retiring partner’s interest and the latter ceases to be a partner.  The tax inquiry, however, is more involved, and the “retirement agreement” should seek to address as many tax issues as possible.

According to IRS regulations, the term “liquidation of a partner’s interest” means the termination of a partner’s entire interest in a partnership by means of a distribution, or a series of distributions, to the partner by the partnership.  The series of distribution may be made in more than one tax year, in which case the partnership interest will not be considered as liquidated, for tax purposes, until the final distribution has been made.  This is so notwithstanding that the partner ceased to be a partner as a matter of state law.  Thus, in the recent Brennan decision, T.C. Memo 2012-209, a retiring partner, who left the partnership in 2002 (but was still owed liquidating payments), was required to report his share of the gain from the partnership’s sale of certain assets in 2003 and 2004, even though no distributions had been made to him in respect of the sale.

It is imperative, therefore, for the partnership, and the partner whose interest is being liquidated, to address the allocation of partnership income and gain both for the year in which he ceases to be a partner as a matter of state law, and for any subsequent years in which “liquidation payments” are being made.

The Final Year

In the case of the year in which the partner withdraws from the partnership, the partner must include his allocable share of the partnership’s income for the portion of the year preceding his withdrawal.  Where the partner’s interest is completely liquidated in the year of withdrawal, the partnership’s tax year will close as to the departing partner; the partnership’s income will usually be allocated to the partner on the basis of an interim closing of the books.  Where the partner’s interest is not immediately liquidated for tax purposes, the partnership’s allocation provisions should be amended to ensure that the partner is not allocated any income subsequent to the date of withdrawal, other than that which is “allocated” to him in liquidation of his interest.

The partnership and the withdrawing partner will also have to consider whether a “tax distribution” should be made to the partner in respect of his share of partnership income for the final year, in addition to his liquidating distribution(s).

They must also be mindful of prior-year partnership tax returns, and particularly the consequences arising out of the examination thereof by the taxing authorities; for example, who controls the examination, and if an adjustment is made that results in more taxable income to the persons who were partners during the earlier year, will a “tax distribution” be forthcoming to the departed partner?

Payment for Assets – 736(b)

In order to adequately address the allocation of partnership income to a retiring partner, the partnership needs to understand what the payments being made to him represent, since they may represent several items.  Before one can characterize the liquidating payments to be made to a retiring partner, the payments must be allocated between the value of the partner’s interest in partnership assets and other payments.  The value of the partner’s share of the partnership’s assets (which will be reflected in an adjusted capital account) must first be determined.  These include all tangible and intangible assets of the partnership.  The valuation placed by the partners upon a partner’s interest in partnership property, in an arm’s-length agreement, will typically be regarded as correct.  In general, the remaining partners are allowed no deduction for these payments, though it may be possible to amortize or depreciate them (subject to anti-churning rules) if the partnership has a Sec. 754 election in effect.

Where money is paid by the partnership to the partner for his interest in partnership assets, the payment is treated as a distribution by the partnership, and the partner recognizes gain to the extent that the amount distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution.  The gain is treated as being realized from the sale or exchange of a capital asset.  For these purposes, the partner’s “relief” from his share of partnership liabilities, which is generally deemed to occur in the year he withdraws from the partnership under local law, is treated as a distribution of money.

However, there are exceptions to this capital sale treatment.  For example, to the extent the money received by the partner in exchange for his partnership interest is attributable to his share of the partnership’s substantially appreciated inventory, he will be treated as having sold or exchanged such inventory and will realize ordinary income.  To the extent the payments are made for the partner’s share of unrealized receivables, where the partnership’s business is capital intensive, once again the partner will realize ordinary income.  The partnership itself should not realize any income on the subsequent sale of such inventory or collection of such receivables.

Other Payments – 736(a)

Certain other assets receive special treatment, depending on the nature of the partnership’s business and of the retiring partner’s involvement therein.  Thus, in the case of a service partnership, a payment for partnership assets will not include the partner’s share of partnership goodwill unless the liquidation agreement specifically provides for a reasonable payment for goodwill and the retiring partner was the equivalent of a general partner.  If these criteria are not satisfied, then any payment that would otherwise cover partnership goodwill would, instead, be treated as a guaranteed payment, producing ordinary income to the retiring partner and a deduction to the partnership.

The portion of the payments made to a retiring partner for his share of unrealized receivables (where the business is not capital intensive) or goodwill (with certain exceptions), or otherwise not in exchange for his interest in other partnership assets, will be considered either a distributive share of partnership income if the amount is determined with regard to the income of the partnership, or a so-called “guaranteed payment” if the amount is determined without regard to partnership income.  In either case, the retiring partner realizes ordinary income.  To the extent they are considered as a distributive share of partnership income, the payments reduce the distributive shares of the remaining partners.  To the extent the payments are considered guaranteed payments, they are deductible by the partnership.

Where liquidating payments are made to a partner during the taxable year, the partner must segregate that portion of each such payment which is determined to be in exchange for the partner’s interest in partnership property from that portion that is treated as a distributive share or guaranteed payment, as described above.  Where the payments are to be made over two or more years, IRS regulations provide rules for making the allocation, though the partners may agree to a different method.

Plan for Taxes

Many of the foregoing tax issues may be addressed in the partnership agreement, well before the departure of any partner.  A well-drafted agreement can facilitate the subsequent liquidation of a partner’s interest.  Alternatively, they may be covered in a liquidation agreement between the retiring partner and the partnership ,or in a settlement agreement in resolution of litigation between the retiring partner and the partnership.

Regardless of where they are addressed, it is important that they be addressed, preferably from the outset.  If the partnership fails to recognize the issues in the first place, it may leave itself open to significant tax cost by failing to generate a deduction, or its equivalent, for the remaining partners.

If the partner and the partnership fail to consider the tax issues, the IRS and the courts may do it for them, with unexpected tax and economic consequences for both parties.