Partner redemptions from ‘dry’ partnerships

Editor: Greg A. Fairbanks, J.D., LL.M.

Taxpayers frequently choose to hold investments in corporate entities through a so–called “dry partnership,” where, rather than directly holding the corporation’s stock, the investors hold interests in an entity classified as a partnership. The dry partnership then holds 100% of the corporation’s stock as its sole asset. The dry partnership structure offers several tax–structuring advantages over direct stock ownership, including facilitating tax–free rollovers as part of subsequent bolt–on acquisitions and the ability to offer partnership profits interests to incentivize the corporation’s employees.

For purposes of this item, we consider a dry partnership that has as its sole asset 100% of the stock of a single corporation and with no partnership–level liabilities or other activity. However, even this basic dry partnership can present far more complex tax issues than might be suggested by the absence of entity–level operations. This focuses on certain structuring considerations that arise when a dry partnership seeks to fully redeem one of its partners prior to a liquidity event.

Partner redemptions generally

Partnership redemptions of partners’ interests are generally not taxable to either the distributee partner or the partnership, except to the extent that the amount of any money distributed exceeds the partner’s basis in its partnership interest prior to the redemption. To the extent the partnership distributes money in excess of the partner’s basis, the partner recognizes gain under Sec. 731(a), which is generally capital gain under Regs. Sec. 1.731–1(a)(3). For partnerships that hold certain unrealized receivables and appreciated inventory items (“hot assets”), a portion of the gain recognized as a result of a redemption may be characterized as ordinary income under Sec. 751(b). However, Sec. 751(b) recharacterization generally does not arise in the context of redemptions from dry partnerships. Property distributions in redemption of the partner’s interest are also generally tax–free, and Sec. 732 and its regulations provide rules for determining a partner’s basis in the distributed property.

A partner whose interest in a partnership is liquidated solely for cash and hot assets, as described under Regs. Secs. 1.751–1(c) and 1.751–1(d), may recognize a loss if the sum of the amount of cash and the adjusted basis in the hot assets in the partner’s hands is less than the partner’s basis in the pre–distribution partnership interest.

Partner exits from dry partnerships

In many cases, investors in dry partnerships expect that the source of liquidity to exit their investment will be the partnership’s ultimate sale of its corporate stock. However, certain partners may need or be required to exit a dry partnership prior to a liquidity event. Because a dry partnership generally holds only corporate stock, the partnership and the remaining partners will need to consider the source of funds needed to facilitate a partner’s exit. In some cases, the exiting partner may simply sell its interest to a new partner. However, this item discusses certain tax considerations for structuring alternatives for partnerships that choose to redeem an exiting partner.

The manner in which a dry partnership sources the funds necessary to redeem a partner can have significant tax implications, not only to the redeemed partner but also to the partnership and its remaining partners. We first discuss three methods in which the corporation’s cash is ultimately used to redeem the dry partnership’s partner. We then discuss the possibility that an existing or incoming partner provides the necessary cash. The methods discussed below are certainly not an exhaustive list of potential options to structure a partner redemption. Further, the optimal choice of redemption structure will depend on all of a partnership’s particular facts.

Cash distribution funded by the corporation

The first and perhaps simplest method of funding the redemption of a partner from a dry partnership is for the corporation to distribute funds to the partnership, which in turn uses the cash to redeem its partner.

The redeemed partner will recognize gain under Sec. 731(a) to the extent the distributed cash exceeds the partner’s basis in its partnership interest prior to the redemption. If the partnership has a Sec. 754 election in effect (or makes one in connection with the redemption), the basis of the partnership’s remaining stock is increased under Sec. 734(b) by the amount of gain recognized by the redeemed partner. Although making the Sec. 754 election and computing a Sec. 734(b) adjustment impose some degree of administrative burden on the partnership, this adjustment might be necessary to avoid distortions in the amount, character, or timing of subsequent gain or loss in connection with partnership–level dispositions of its corporate stock. Additionally, since the basis adjustment is on nonamortizable and nondepreciable property, i.e., corporate stock, this reduces some of the administrative burden of making a Sec. 754 election.

Because the cash is not transferred directly to the redeemed partner, the consequences of the corporate distribution are first analyzed at the partnership level. Rules under Sec. 301(c) generally provide that a corporate distribution is treated as a dividend to the extent of the corporation’s earnings and profits (E&P), as determined under Regs. Sec. 1.316–1. Distributions in excess of the corporation’s earnings reduce the shareholder’s basis in its stock, and to the extent the distribution exceeds such basis, the excess generally results in capital gain. If the corporate distribution resulted in dividend or capital gain income at the partnership level, the partnership’s allocation of the income and gain could affect all of the partners of the partnership.

Specifically, when a partnership recognizes income and gains, the partnership has to determine how it is required to allocate such income and gains among its partners. The allocation of the partnership’s income, gains, deductions, and losses is guided by Sec. 704(b) and the allocation provisions within the partnership agreement. Some partnership agreements seek to “stuff” the partnership–level income to the redeemed partners and away from the remaining partners that do not receive cash in the transaction. Such allocations should be evaluated in light of Sec. 704(b) and the regulations thereunder. Alternatively, other partnership agreements might contain allocation provisions that simply allocate any dividend or capital gain among all partners like any other income.

Once Sec. 704(b) is applied to the allocation, any capital gain could be subject to the Sec. 704(c) allocation rules, which would require that tax items be allocated to specific Sec. 704(c) partners. As a result, although the redeemed partner is the ultimate recipient of the distributed cash, other partners in the partnership could be allocated dividend income and capital gain. Accordingly, corporate distributions to the partnership can affect the tax liability of the remaining partners in addition to the partner that is being redeemed. If this is the case, the corporation may need to distribute additional cash to allow the partnership to make tax distributions to the partners that are recognizing income and gain.

An additional technical analysis may be required to the extent a corporate distribution exceeds its E&P and will offset the partnership’s basis in its stock under Sec. 301(c)(2). Where the partnership has received contributions of corporate stock from multiple partners or has made contributions to the corporation at varying times (perhaps in connection with the addition of new partners over time), the partnership may have multiple blocks of stock with varying basis in each. A detailed discussion of whether a corporate shareholder must track its basis separately for each of its blocks of stock (potentially treating a distribution as a return of basis for one block while recognizing capital gain with respect to another) or whether it may aggregate the basis of all its blocks into a “unitary” stock basis is beyond the scope of this item. However, the issue highlights the complexity that can present itself in even the simplest partner redemption transactions involving dry partnerships.

Partnership distribution followed by corporate redemption

The second method is a two–step approach in which the dry partnership first distributes a portion of its corporate stock out to the to–be–redeemed partner in complete liquidation of its partnership interest. The corporation then redeems its stock directly from the former partner.

In ideal situations, neither the partnership nor any of the other partners will recognize gain on the partnership’s distribution of stock in redemption of the exiting partner. The complete redemption of the former partner, assuming it qualifies for redemption treatment under Sec. 302, results in the recognition of gain by the redeemed partner. The distribution of cash from the corporation in redemption of the former partner’s stock does not affect the taxable income of the partnership or any of its remaining partners.

While the distribution of property to a partner is generally a nonrecognition event, care should be taken in several circumstances. First, if the redeemed partner previously contributed cash to the partnership, the disguised-sale rules under Sec. 707(a)(2)(B) and Regs. Sec. 1.707-6 may treat the initial transfer of cash and subsequent distribution of stock as a sale of such stock to the redeemed partner, particularly if the redemption occurs within two years of the prior cash contribution. In that case, what was otherwise anticipated to be a tax-free distribution may result in recognized gain at the partnership level to be allocated among the partnership’s remaining partners (none of which received cash or property in connection with the redemption).

The two–step redemption method may also present complications if any of the partners previously contributed property to the partnership. Distributions of stock to a redeemed partner within seven years of any such contributions should be evaluated under the so–called mixing–bowl rules in Secs. 704(c)(1)(B) and 737.

Sec. 704(c)(1)(B) generally requires a partner that contributes property to a partnership to recognize any remaining built–in gain or loss if the contributed property is subsequently distributed to another partner within seven years. If any of the remaining partners previously contributed the corporation’s stock or, perhaps, contributed other property to the corporation in exchange for stock, consideration should be given to whether Sec. 704(c)(1)(B) and Regs. Sec. 1.704–4 require that contributing partner to recognize any remaining pre–contribution built–in gain or loss upon the distribution of stock to the redeemed partner.

Likewise, if the exiting partner previously contributed any property to the partnership other than shares of the distributed corporation, Sec. 737 may require the redeemed partner to recognize gain in connection with the distribution as determined under Regs. Sec. 1.737–1. However, any gain recognized under the mixing–bowl rules to the redeemed partner ought to offset gain that would otherwise be recognized upon the corporation’s subsequent redemption of its stock.

Taxpayers should also evaluate whether the transfer of cash to the redeemed partner can be respected as a redemption of corporate stock directly from the former partner. Given that the partner holds only transitory ownership of the stock, there could be a risk the transaction is instead characterized as a transfer of cash from the corporation to the partnership, followed by the partnership’s redemption of the partner. A deemed distribution of cash by the corporation to the partnership would present the same issues discussed with the first method above.

In summary, the two–step redemption method provides the potential to use the corporation’s cash to redeem a partner while isolating the potential gain associated with that distribution to the redeemed partner. However, the method also requires additional substantive scrutiny, and the path to ensure the redemption is tax–free to the partnership’s remaining partners is lined with traps for the unwary.

Loan from corporation to the partnership

Where the distribution of cash from the corporation would be expected to result in taxable income at the partnership level, the parties might consider having the partnership borrow the funds necessary to redeem a partner from the corporation or another entity under the corporate structure. The principal tax issue presented by this approach is the potential recharacterization of the loan to the partnership as a distribution. It may be difficult to sustain the parties’ intended loan treatment where the “borrower” partnership lacks any operating income or other assets to repay the loan. Tax consequences similar to those discussed above (including potential partnership–level taxable income) could arise if an advance papered as a loan were recharacterized as a corporate distribution.

Cash contribution from other partners

The final method discussed in this item looks to either existing or incoming partners to provide the cash to be used by the partnership to redeem its partner. That is, the redemption transaction is structured so that one or more partners first contribute cash to the partnership for a new or increased partnership interest. Then the partnership uses the cash to redeem out the exiting partner. As with the corporate–loan method discussed above, the key consideration with this approach is whether the tax characterization of the transaction will follow its form.

A detailed discussion of situations in which related contributions and distributions in redemptions of a partner may be recharacterized as a sale of a partnership interest is well beyond the scope of this item. While the simple interrelatedness of the contribution and redemption might suggest a sale, several factual circumstances may increase the likelihood that the redemption is recast. These circumstances could include direct negotiations between the contributing and exiting partners and the receipt by the contributor of a partnership interest that is identical to the interest that is relinquished by the exiting partner. Although most practitioners have long acknowledged the possibility that related contributions to and distributions from a partnership could be treated as sales of partnership interests in appropriate circumstances, the tax law known as the One Big Beautiful Bill Act, H.R. 1, P.L. 119–21, modified Sec. 707(a)(2)(B) to clarify this possibility, notwithstanding the absence of specific implementing regulations.

The tax consequences of a recasting from a cash contribution and subsequent redemption to a sale of a partnership interest are perhaps not as dire a result compared to a recasting in the corporate loan or two-step redemption methods discussed above, particularly in a situation in which the exiting partner is fully redeemed (and thus applies its full basis against the sale price in determining gain or loss realized). However, it is worth noting that in the sale scenario, the exiting partner’s capital account will transfer to the buyer under Regs. Sec. 1.704-1(b)(2)(iv)(l) and that the adjustment to the basis of the partnership’s asset (if the partnership has a Sec. 754 election in place) is made pursuant to Sec. 743(b) and is personal to the purchasing partner(s), as compared to the adjustment made to the partnership’s common basis pursuant to Sec. 734(b) in the case of redemption.

Analysis and planning required

The approaches above represent some of the common approaches taken by dry partnerships seeking to redeem a partner. As we have highlighted, even the apparently simple task of redeeming a partner from a partnership with no operating assets or liabilities can entail detailed technical analysis. Proper planning for partner redemption transactions can help ensure a redemption does not unexpectedly result in allocation or recognition of taxable income to the remaining partners.

Editor

Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.