Termination of a Partnership Interest

By Cynthia L. Dulworth, CPA

Editor: Stephen E. Aponte, CPA

This item explores the two main methods used when terminating a partnership interest: purchase and liquidation. A terminating partner may sell his or her interest to one or more of the remaining partners, or the partnership may liquidate his or her interest. The tax issues associated with these two methods, such as whether the change generates ordinary income or ordinary deductions or capital gain treatment for the partnership and for the terminating partner, should be considered in detail. How the partnership treats the termination is important to both parties in order to receive the tax treatment intended.

Purchase of a Partner's Interest

Under the purchase scenario, one or more remaining partners may buy out the terminating partner's interest for fair market value (FMV) plus any relief of debt realized by the partner. If the FMV of the partnership assets is greater than their associated tax basis, it is usually advantageous for the partnership to make a Sec. 754 election to step up the basis of the assets under Secs. 734(b) and 743(b). However, once the partnership makes the election, it stays in effect for any subsequent sale until the partnership requests the election to be rescinded. The acquiring partners' incremental change in ownership now has a basis equal to FMV.

The Sec. 754 election must be applied to each asset of the partnership. The difference between the FMV and the tax basis of each asset determines whether the asset will receive a step-up or a stepdown. If the partnership elects Sec. 754 treatment, any assets that have declined in value must be stepped down, just as the appreciated assets will be stepped up. There is no picking or choosing which assets are to be considered. Also, if a subsequent buyout of a partnership interest is below FMV, then the step-down rules must also apply under this election.

The benefit of this election is that the acquiring partners are allowed to take additional deductions as the assets that generated the step-up are disposed of or depreciated. Likewise, if there is a stepdown, the book deduction will be reduced. In theory, if all the assets were disposed of, the acquiring partner's interest would end up back at book basis.

Without the Sec. 754 election, the incremental value of the partnership interest purchased will stay on the acquiring partners' books until the partnership interest is terminated. The Sec. 754 election will create additional accounting work to maintain the two sets of books necessary to track the adjusted assets and their disposal. To make the Sec. 754 election, the partnership must attach a statement to Form 1065, U.S. Return of Partnership Income, for the year of the sale, which should include the partnership name, address, and tax year in effect. It should also include a declaration that the partnership elects to apply the provisions of Secs. 734(b) and 743(b), and it should be signed by a partner.

Under the purchase scenario, the terminating partner is treated as having sold his or her partnership interest, usually receiving capital gain treatment. If the proceeds of the sale include property other than cash, the difference between the FMV and the tax basis of this property is realized as gain at the time of the sale. The installment sale rules can also apply if there are multiple payments and at least one payment will be received more than one year from the sale date.

If the transaction is structured as an installment sale, the outside basis of the partnership interest is prorated and applied against each payment. The resulting proportion of the total gain is realized each time a payment is received. In the year of sale, the terminating partner will receive a final Schedule K-1, and there is no impact on the other partners that were not involved in this transaction.

Caution: Partnerships must be careful when using the purchase scenario. The sale of 50% or more of the partnership's capital and profits interests within a 12- month period terminates the partnership under Sec. 708(b)(1)(B).

Liquidation of Partner's Interest

The second method this item will discuss is where the partnership liquidates the terminating partner's interest. The partnership may use its assets to liquidate the partner's interest, or it can take on debt to liquidate the partner's interest. The remaining partners cannot fund the liquidation, nor may these partners make the liquidating payments on behalf of the partnership. If they do, the transaction is treated as a sale as described above. The remaining partners should also be careful in making capital calls so that the substance of the capital calls cannot be construed as being used as a payment to liquidate the partner's interest.

All payments to a partner in liquidation are treated as either Sec. 736(a) or Sec. 736(b) payments. Sec. 736(a) payments are for a continuing share of partnership income or for guaranteed payments. Sec. 736(a) payments also include payments for unrealized receivables and for goodwill when goodwill payments are not called for in the partnership agreement. This treatment for unrealized receivables and goodwill applies only to general partners in partnerships where capital is not a material income-producing factor. Payments for goodwill are treated as payments under Sec. 736(b) for all capital-intensive partnerships or where the partnership agreement specifies that terminating payments may be made for goodwill (Sec. 736(b)(2)(B)).

Sec. 736(a) payments are deductible by the partnership and are ordinary income to the liquidating partner, subject to self-employment tax. A cash-basis partner should be aware that if the partnership accrues a payment to the partner in its tax year, the partner must recognize that income in the same tax year.

Liquidating payments that are not Sec. 736(a) payments are Sec. 736(b) payments and are considered nondeductible distributions of partnership property. These payments generally receive capital gain treatment for the liquidating partner. Liquidation may be accomplished using deferred payments. These deferred payments are not taxed to the liquidating partner until the payments received exceed his or her outside basis. However, the partner can make an election to prorate the basis, if desired. If the partner makes this election, gain will be recognized proportionately as in the purchase scenario.

As with a purchase, the partnership may make the Sec. 754 election for liquidating payments. If the partnership makes the election, payments to the liquidating partner exceeding his or her tax basis capital account will generate a step-up in partnership assets. Otherwise, without the Sec. 754 election, the excess payments create a phantom asset and are nondeductible by the partnership.

The liquidating partner is not considered terminated from the partnership until the last liquidating distribution is made. The liquidating partner will no longer receive profit and loss allocations of the partnership after the date of termination; however, the partner will still receive a K-1 each year until the final payment is made. It should also be noted that a liquidation is not considered a sale or exchange that can cause a termination of a partnership interest under Sec. 708.

Hot Assets

Under both the purchase and liquidation methods discussed above, a partner may have to recognize ordinary income rather than capital gain income. Unrealized receivables and substantially appreciated inventory are considered "hot assets" under Sec. 751. If the partnership holds hot assets at the time of sale or liquidation, the portion of the gain attributable to these assets will be considered ordinary income.

Note that if the sale is treated as an installment sale, the ordinary income due to the sale of hot assets will have to be recognized at the time of the sale and will not be allowed installment sale treatment (CCA 200722027). A further discussion of hot assets is beyond the scope of this item, but be aware that there are reporting obligations related to hot assets.


The above discussion demonstrates that while both the purchase and liquidation methods of terminating a partnership interest are viable, the liquidation method affords the parties more flexibility. In some cases, a liquidation can be structured to allow the partnership a current deduction for a portion of the payments. Similarly, a terminating partner might prefer a liquidation because of the ability to defer income until his or her basis is recovered. Whichever method is chosen, care must be taken to ensure that all parties receive the tax treatment that is intended.



Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or saponte@hrrllp.com.

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