Structuring Partnership Payments to a Retiring Partner

Sec. 736 classifies payments made by an ongoing partnership to liquidate the interest of a retiring or a deceased partner's successor-in-interest. The purpose underlying the passage of Sec. 736 was to eliminate the prior uncertainties in the taxation of partner retirements.

These uncertainties arose because payments made to a retiring or a deceased partner's successor were often a combination of payments for the partner's share of partnership property and payments that represent the partner's share of continuing partnership income. Sec. 736 clarifies this situation by classifying payments for the partner's share of partnership property under Sec. 736(b) and classifying income payments under Sec. 736(a). The Sec. 736 liquidation rules apply only when the retiring or deceased partner, or the successor to the deceased partner, receives a distribution or distributions in complete liquidation of the partner's interest in the continuing partnership.

Sec. 736(b) payments are payments made to the retiring or deceased partner's successor in exchange for the retiring partner's interest in partnership property. It is useful to think of these payments as being made in lieu of distributing to the partner or the successor a proportionate share of each partnership asset. Sec. 736(a) payments include all payments not classified as Sec. 736(b) payments, such as:

1. Payments for the distributee partner's share of partnership unrealized receivables, to the extent the receivables do not have basis to the partnership and if the payments are reclassified as Sec. 736(a) payments under Sec. 736(b)(2)(A).

2. Payments for goodwill not provided for in the partnership agreement, to the extent goodwill does not have any basis to the partnership and if the payments are reclassified as Sec. 736(a) payments under Sec. 736(b)(2)(A).

3. Payments for the distributee partner's share of partnership unrealized receivables and goodwill generally will not be reclassified as Sec. 736(a) payments if the distributee partner is a limited partner or if capital is a material income-producing item in the partnership.

Sec. 736(a) rules will not apply when a partner is a limited partner or when capital is a material income-producing factor for the partnership. Rather, all payments are treated as payments in exchange for partnership property (Sec. 736(b)). Therefore, the importance of Sec. 736 relates mainly to service-oriented partnerships (such as general partnerships in the practice of medicine, dentistry, law, architecture or accounting).

When a general partner in a partnership in which capital is not a material income-producing factor retires, payments received for the partnership interest will be divided into the following categories:

1. Unrealized receivables;

2. Goodwill; and

3. Everything else (e.g., real estate, leaseholds, equipment, etc.).

The term unrealized receivables is more narrowly defined for Sec. 736 purposes than it is for Sec. 751 (hot assets) purposes. It only includes amounts for services rendered (or to be rendered) and goods delivered (or to be delivered) not previously included in the partnership's income. Put simply, this would be mainly cash-basis accounts receivable and unbilled work in process. It excludes recapture items treated as unrealized receivables for Sec. 751 purposes. However, payments to retiring partners for their share of depreciation recapture and other ordinary income items will be treated as distributions in exchange for a retiring partner's interest in partnership property. As a result, the payments will be subject to the Sec. 751 rules. Therefore, even though the payments will not be ordinary income under Sec. 736 as unrealized receivables, they could be ordinary income under Sec. 751(b) on a disposition of partnership property.

When capital is not a material income-producing factor, partners may treat a payment to a retiring general partner as goodwill under either:

1. Sec. 736(a), as a distribution of the partner's share of profits or guaranteed payment (depending on whether the amount is contingent or fixed) or

2. Sec. 736(b), as a distribution.

The partnership and retiring partner may elect to treat the payment as a distribution by simply providing in the partnership agreement that a retiring partner is to be paid for goodwill. Most of the time, partnership agreements are silent on this issue, and the payment for goodwill is then treated as a guaranteed payment (if fixed in amount) or as a share of the profits (if contingent).

Goodwill payments treated as Sec. 736(b) payments are treated under the normal distribution rules that can trigger adjustments to the remaining partnership assets under Secs. 754 and 734(a). When a Sec. 754 election is in effect the basis increase, which is allocated to goodwill, would be amortized over 15 years.

If a retiring general partner in a partnership in which capital is not a material income-producing factor will be receiving payments over several (i.e., 15 or more) years, the partnership agreement may want to provide for the payment of goodwill and a Sec. 754 election should also be in effect.

Because the retiring partner will get capital-gain treatment for the goodwill and therefore pay less tax, the partnership could offer the partner slightly less to compensate for the ordinary deduction being amortized over 15 years. The adjustment to the partnership property basis should coincide, both in timing and in amount with the retiring partner's gain recognition. Therefore, the basis step-up will occur each year as the payments are made.

Basis that arises from a contingent liability must be allocated to the acquired assets under the residual method. For a partially depreciated (or amortized) asset, Prop. Regs. Sec. 1.168-2(d)(3) allows increased deductions over the remaining life to account for depreciation that would have been allowed between the acquisition and the date of the price adjustment. In other words, the basis would be stepped up as the payments were made to the retiring partner; however, the amortization period would be over the remaining original 15-year period versus taking each step-up over a new 15-year amortization period.

The retiring partner should be paid less, by finding the breakeven point at which the tax consequences to the remaining partners would be the same if ordinary payments were made and deducted as paid, versus goodwill payments being paid and deducted over 15 years. The retiring partner can still come out ahead in net cashflow, by receiving less and paying tax at capital-gain rates, with no tax hardship to the remaining partners. Taxpayers should consider this, as most would initially view receiving ordinary income payments to be more advantageous, because the remaining partners will get an immediate deduction.

From Lisa M. Loychik, CPA, MT, Cohen & Company, Ltd., Youngstown, Ohio