November 1, 2023 •Oak Street Funding
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Eventually, most partnerships will reach the point when one of the partners is ready to retire or step away from the partnership for other reasons. That will trigger what's known as a partner buyout. Partnerships may give considerable thought to that eventuality, but they must also consider the partner buyout tax implications.
What is a partner buyout?
In simple terms, a buyout involves the dilution of one partner, often at the benefit of another partner or partners. In some cases, the business organization, such as a partnership, repurchases an individual owner’s stake. These partnerships can be structured as limited liability companies, corporations, limited liability partnerships, or another organization prescribed by applicable state law.
Typically, the purchase is considered a capital transaction, which carries a lower tax rate than if it were classified as ordinary income. However, most partnership buyouts become more complicated because they involve a mix of capital and ordinary income. While the tax implications can be complicated, they create opportunities for taking tax-advantaged approaches.
Ideally, the organization’s partnership should explore and consider these issues when developing the partnership agreement. That agreement should clearly spell out the terms of partner buyouts and buy-ins, so nobody is surprised by the tax consequences when buyouts occur. This may include, but is not limited to, the determination of value at the time of the transition.
What is the value of a partner’s share?
There are several methods and applications to determine the value of a partner’s share. The Revised Uniform Partnership Act (RUPA) establishes the price of a partner’s share as the value of the partner’s percentage of the partnership’s total property less the percentage of any partnership liabilities as of the day the departing partner separates from the partnership.
The tax basis for the departing partner’s payment is the sum of their initial investment, any additional capital contributions made during their tenure as a partner, and their share of business income during that time, all reduced by their percentage of any business losses and distributions.
Redemption of assets or sale?
In determining partner buyout tax implications, a key consideration is whether the transaction is considered “redemption” or “sale.” In a redemption, the partnership purchases the departing partner’s share of the total assets.
In a sale, the payments represent the proceeds of the sale of the departing partner’s interest to one or more of the remaining partners. Both approaches involve an increase in the share of the partnership for either some or all the remaining partners, while the departing partner receives cash or other property.
How are the payments classified?
Section 736 of the Internal Revenue Code details whether payments made to liquidate the partnership are considered a capital gain/loss or ordinary income and whether payments by the remaining partners are deductible.
These rules apply only in buyouts in which the departing partner receives payments directly from the partnership. If the remaining partners instead use their own funds to buy out the departing partner’s interests, other rules apply. Payments directly from the partnership will fall into one of two Section 736 categories:
IRC Section 736(a) payments
If the liquidation involves guaranteed payments whose amounts are not tied to the partnership’s income, or if the payments are not guaranteed but linked directly to the partnership’s performance, they fall under Section 736(a).
The partner who is leaving must claim them as ordinary income, which tends to be taxed at a higher rate. However, the remaining partners can deduct those payments and reduce the partnership’s tax liability.
IRC Section 736(b) payments
On the other hand, payments that represent a distribution (or liquidation) of the departing partner’s share of any partnership assets are not deductible by the remaining partners.
The departing partner will treat the payments, less their tax basis, as a capital gain (unless the payments are less than the tax basis, in which case they’d be considered a capital loss). There are two important exceptions related to “hot” assets and when the payments involve the distribution of goodwill.
The departing partner and any remaining partners may have a friendly working relationship, but both parties have competing interests when it comes to tax consequences. The partnership benefits when as much of the buyout amount as possible falls under Section 736(a) because the partnership is allowed to deduct the payments, reducing their tax burden.
On the other hand, the departing partner generally comes out ahead when the bulk of payments can be classified under Section 736(b), given that any amounts above the tax basis will be treated as capital gains and taxed at a lower rate than the ordinary income received under Section 736(a).
Are there hot assets?
Another critical consideration focuses on whether any of the partnership’s assets at the time of the sale are considered “hot.” In this context, “hot” is an IRS description that primarily refers to assets falling into the broad category of unrealized receivables such as unsold inventory and accounts receivable.
Hot assets may become an issue because they can generate income over time. If the departing partner’s distribution includes any hot assets, that portion of the distribution must be recorded as ordinary taxable income.
What if goodwill is included?
If part of the buyout involves goodwill (excess payment over the partner’s share), the tax treatment will depend upon how the partnership agreement classifies goodwill.
Should the agreement specify that the portion of the payment reflecting goodwill falls under Section 736(a), the departing partner must report it as ordinary income, while the remaining partners may deduct it. If the agreement places it under Section 736(b) rules, it’s considered a capital gain for the departing partner, and no deduction is allowed.
What is the payment timeline?
Partnership buyouts that include deferred payouts generally provide more benefits to the departing partners than to those remaining. When payments are received in multiple years, the departing partner should be able to recover the full tax basis before having to recognize any capital gains.
Consult with a professional
This blog post is intended to provide general information and should not be considered specific advice related to your situation. Before planning or taking any action, be sure to consult with your CPA and/or attorney about the tax and other legal consequences that may be associated with your transaction.
