Multiyear redemption payments under a partnership promissory note

Editor: Rochelle Hodes, J.D., LL.M.

Much has been written on tax issues associated with Sec. 751(b) and redemptions of partnership interests. Redemption of a partner’s interest in a partnership can occur for reasons including a transaction involving recapitalization of the partnership or simply a buyout of a retiring or deceased partner. This item focuses on complexities arising under Secs. 736(b), 751(b), 734(b), 704(c), and 752 when partners’ interests are redeemed with payments made over multiple tax years and how these complexities are exacerbated when the redeemed partner receives a promissory note. It further addresses situations where, in exchange for the redeemed partner’s entire interest in the partnership, the partnership will undertake a legal obligation to pay the redeemed partner by issuing the partner a promissory note with a stated principal amount, an interest component, and fixed payment dates.

Redemption with a promissory note

Sec. 736 governs payments made in liquidation of a retiring or deceased partner’s interest if the partner ceases to be a partner under local law. Sec. 761(d) defines “liquidation of a partner’s interest” as termination of the partner’s entire interest in a partnership by means of a distribution or a series of distributions to the partner. Regs. Sec. 1.761–1(d) adds that the partner’s interest will not be considered liquidated until the final distribution has been made.

Sec. 736 divides these continuing payments into two categories: (1) distributions under Sec. 736(a) that represent a distributive share or a guaranteed payment or (2) distributions under Sec. 736(b), where the payment is made in exchange for partnership property. The analysis in this article assumes that capital is a material income–producing factor. As such, Sec. 736(a) payments made to retiring general partners for unrealized receivables and goodwill is not addressed.

If Sec. 736(b) applies, then generally, gain or loss with respect to the property is determined under Sec. 731(a), which provides for recovery of a partner’s basis and gain recognition upon distributions of cash or certain marketable securities in excess of basis that is generally treated as capital gain under Sec. 741. An important exception in Sec. 751(b)(1)(A) applies to unrealized receivables or substantially appreciated inventory, for which ordinary gain or loss may be recognized prior to the calculation of any remaining capital gain or loss under Sec. 741. Inventory for Sec. 751(b) purposes must have “appreciated substantially in value” — i.e., its fair market value (FMV) exceeds 120% of the adjusted basis to the partnership of such property (Sec. 751(b)(3)).

When a redeemed partner receives a promissory note from the partnership, the threshold question is whether the promissory note is partnership property (in which case the partner is treated as fully redeemed as of the redemption date) or whether it is a deferred distribution (in which case the partner is not treated as fully redeemed until the final payment occurs). (For an excellent discussion on this issue, see Kim and Saunders, “Redeeming a Partner With the Partnership’s Note,” Tax Management Memorandum (March 21, 2016)). The rules under Sec. 736 do not dictate which treatment applies, and there is no formal guidance on how Sec. 736 operates under either treatment. However, the capital–account–maintenance rules under Sec. 704(b) provide guidance on how to treat situations where the partnership is the maker of a promissory note and either the note is contributed to a partnership by a partner (i.e., the note is partnership property) or the note is distributed to a partner (i.e., payments under the note are deferred distributions). The general rule in both cases is that a partner’s capital account is decreased only when there is a taxable disposition of the note or principal payments are made on it. Regs. Sec. 1.704–1(b)(2)(iv)(e)(2) provides two exceptions to the general rule where the promissory note is readily tradeable on an established securities market or the note is negotiable.

This item focuses on situations where the note is not treated as property, the partner’s entire partnership interest is redeemed, and the partner is no longer a partner under state law. Accordingly, if the redeemed partner receives a promissory note at the time of the redemption and payments under the note are treated as merely a right to deferred partnership distributions, the liability would not be considered a liability of the partnership for tax purposes. As such, the stated “interest” on the note would not be viewed as true interest expense to the partnership (or interest income to the redeemed partner). Instead, consistent with Sec. 736(a), the interest component of the payment on the note would more appropriately be treated as a guaranteed payment and reported accordingly. Additionally, there would be no impact on the redeemed partner’s capital account or outside basis at the time of the issuance.

Issues when treating the note as a deferred distribution

Impact of Sec. 752:One collateral effect of treating the promissory note as a deferred distribution is that the promissory note is not considered a liability for Sec. 752 purposes and therefore is not accounted for on the partnership’s Sec. 704(b) or tax balance sheets. Moreover, since it is assumed that the promissory note does not constitute property, there is no immediate distribution that would give rise to taxation under Sec. 731(a) unless there is a deemed distribution under Sec. 752(b) as a result of a reduction in liabilities allocable to the redeemed partner. Care needs to be taken on how to address the potential triggering of gain under Sec. 731(a) of a deemed cash distribution when liabilities are no longer allocable to the redeemed partner. If there is a deemed distribution under Sec. 752(b), Sec. 751(b) may also apply, which could alter the timing and character of gain recognition, as discussed later in this item.

A partnership allocates nonrecourse liabilities to its partners using a three–tiered approach in Regs. Sec. 1.752–3(a): first, to the partners’ shares of Sec. 704(b) minimum gain; next, to the partners’ shares of Sec. 704(c) minimum gain; and finally, to the partners’ shares of partnership profits. Although a full discussion is outside the scope of this item, minimum gain under Secs. 704(b) and 704(c) is generally the extent to which the face value of debt exceeds the Sec. 704(b) basis and tax basis, respectively, of the encumbered property. See Regs. Sec. 1.752–3 for further flexibility regarding the third tier of allocations. The partnership operating agreement may contain language addressing the approach that will be taken in the third tier. Since a redeemed partner generally does not have an interest in future profits or losses, except in rare circumstances, the nonrecourse liabilities should be allocated only to the first two tiers in the case of a redeemed partner.

For example, assume a partner contributed property to the partnership that was subject to nonrecourse debt, the tax basis of the property was lower than the liability assumed by the partnership, and therefore Sec. 704(c) minimum gain exists. If the property is still subject to nonrecourse debt when the partner is redeemed, the liability will continue to be allocated to the partner under the Sec. 752 second tier during the redemption period even after the partner ceases to legally be a partner in the partnership. This is particularly meaningful if, at the time of the redemption, the redeemed partner had an adjusted basis in the partnership that was less than that partner’s share of allocable debt (i.e., the redeemed partner had a negative tax capital account), unless outside basis is otherwise higher than inside capital plus allocable debt (e.g., where there is a purchased or inherited property basis step–up). If, instead, the nonrecourse liabilities are not allocable to the redeemed partner at the time of the redemption, the liabilities allocable to the partner are reduced, and therefore the partner may recognize gain under Sec. 731(a) (and/or Sec. 751(b)) on the date of the deemed distribution to the extent of the negative capital account.

Further complications under Sec. 704(c): Sec. 704(c) generally requires the partnership to track built–in gain or loss on property contributed to the partnership or upon revaluations of Sec. 704(b) capital accounts. In most cases, when a partner is redeemed — including a redemption where the partner receives a promissory note — the redeemed partner has no interest in future profits or losses and will not be receiving any allocations under Sec. 704(b). Therefore, it is tempting to assume that if the partner has a Sec. 704(c) built–in gain or loss at the time of redemption — with or without a Sec. 704(b) revaluation of the Sec. 704(c) property at the time of the redemption — Sec. 704(c) is not relevant, as the redeemed partner would not receive any allocations of income or loss for any period after agreeing to be redeemed. Although the promissory note may not be a property distribution for tax purposes, it may be appropriate for the partnership to revalue Sec. 704(b) capital accounts pursuant to Regs. Sec. 1.704–1(b)(2)(iv)(f) at the time of the redemption using contemporaneous information on capital account and asset value, as discussed further in relation to Sec. 751(b). However, if the partnership sells the Sec. 704(c) property after the partner is redeemed but before the promissory note is paid, the partnership can determine that Sec. 704(c) gain or loss associated with the sale should result in a tax allocation to the redeemed partner, even though the redeemed partner is no longer legally a partner in the partnership.

Timing of gain recognition and basis adjustments: A further complicating factor is the timing of gain recognition under Sec. 731(a) and basis adjustments under Sec. 734(b) and their effect, if any, on the Sec. 704(c) responsibility of a redeemed partner and the remaining partners. Partnerships with Sec. 754 elections in effect are required to record basis adjustments as the redeemed partners recognize gain under Sec. 731(a) (Rev. Rul. 93–13). To the extent the redeemed partner had a prior Sec. 704(c) built–in gain responsibility, it might be reasonable to conclude that this responsibility would decrease as the redeemed partner recognizes Sec. 731(a) gain, so that the allocations to the redeemed partner do not include the portion of the deferred gain inherent in the partner’s tax basis that has effectively been recognized under Sec. 731(a). Unfortunately, there is no guidance under the normal allocation rules on basis adjustments under Sec. 755 regarding how to allocate the partnership’s basis adjustment in this case under Sec. 734(b). There is also no guidance under Sec. 704(c). If there is no direct reduction in the Sec. 704(c) built–in gain responsibility of the redeemed partner, future Sec. 704(c) allocations could result in the redeemed partner’s being allocated more gain from the partnership than if the Sec. 704(c) property had been sold prior to the partner’s being fully redeemed, thereby leaving the partner with unrecovered tax basis and a potential capital loss on final redemption. The nonredeemed partners could have a corresponding deferral of tax.

Whether the partnership revalues its assets at the time of redemption: Numerous tax issues may arise if the partnership chooses not to revalue Sec. 704(b) capital accounts immediately prior to the redemption, where the redemption price of the redeemed partner’s interest is different than the partner’s Sec. 704(b) capital account. What does the partnership do if the redeemed partner’s capital account remains positive after all redemption distributions are made? Alternatively, what happens if the redeemed partner’s capital account is negative? The partnership’s operating agreement provisions are unlikely to contemplate this eventuality, and there may be implications for future income allocations and even economic rights. We will return to the revaluation consideration after addressing the general implications of Sec. 751(b).

A distribution that changes a partner’s interest in Sec. 751(b) assets is treated, in substance, as a taxable exchange of Sec. 751(b) property for other partnership property (Regs. Sec. 1.751–1(b)(1)). This deemed exchange can trigger tax to both parties — typically, ordinary gain or loss to the redeemed partner and capital gain or loss to the continuing partnership — and it generally creates an FMV cost basis in the assets treated as exchanged. In effect, the partnership obtains a cost–basis adjustment to Sec. 751(b) property similar to what would arise under a Sec. 754 election, even if no such election has been made. These mechanics are deemed to take place immediately prior to the distribution of non—Sec. 751(b) property. Therefore, the partner’s Sec. 751(b) gain recognition reduces gain recognized under Sec. 731(a), and the partnership may step up its basis in Sec. 751(b) property that effectively reduces the basis adjustment under Sec. 734(b).

Proposed regulations under Sec. 751(b) issued in 2014 (REG–151416–06) but never finalized (and without a stipulation that they may be relied upon prior to finalization) adopt a hypothetical–sale approach that focuses on each partner’s share of net gain or loss inherent in the partnership’s assets, which would resolve the potential issue of the deemed–exchange mechanic resulting in gain recognition to both the partnership and the redeemed partner. The proposed regulations allow the hypothetical sale, however, only if the partnership revalues its assets and adjusts Sec. 704(b) capital accounts to reflect unrealized appreciation or depreciation and the corresponding allocations (Prop. Regs. Sec. 1.751–1(b)(2)(iv)).

Consistent with the underlying framework of the proposed regulations, if, when a promissory note is issued, the partnership does not revalue its assets and adjust its Sec. 704(b) capital accounts to reflect unrealized appreciation or depreciation and the corresponding allocations, it could be extraordinarily complex to measure the Sec. 751(b) shift when promissory note payments are made, given that the shift could change based on changes to Sec. 751(b) property in subsequent years. Therefore, serious consideration should be given to doing such a revaluation when a partner is redeemed with a promissory note issued by the partnership.

If there is a Sec. 704(b) revaluation, the Sec. 751(b) calculation in relation to the redemption is typically performed at the time of the redemption, even though payments will be made over multiple tax years. As payments are made, a corresponding amount of Sec. 751(b) gain should be recognized along with any gain under Sec. 731(a). Under the current regulations, the partnership is required to provide information with its tax filing only regarding the recognition of Sec. 751(b) gain by the partnership (Regs. Sec. 1.751–1(b)(5)). Form 1065, U.S. Return of Partnership Income, and Schedule K–1, Partner’s Share of Income, Deductions, Credits, etc., provide very little guidance in relation to this reporting requirement. The 2025 instructions for Schedule K–1 include for line 11 a Code L referring to Sec. 751(b) but without elaboration.

An area of complexity

Even the simplest redemption agreement may result in complex tax technical considerations. Taxpayers engaging in these transactions should be prepared for this complexity and seek advice on the decision to revalue partnership interests for Sec. 704(b) purposes and the potential implications of Secs. 704(c), 751(b), and 734(b) on an otherwise straightforward Sec. 736(b) payment to a retired or deceased partner.

Editor

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, DC.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Unless otherwise noted, contributors are members of or associated with Crowe LLP.