Question

Sam, Stan, Sue and and Sean have have a partnership in which each of them own a 25% interest in the business. The books are maintained by a CPA who set it up based on the cash method of accounting. The balance sheet has Cash, Accounts Receivable, Inventory, Equipment, Land and other assets. Sam wants out. He is thinking of different alternatives that might be used to terminate his ownership. The ones he has come up with so far are: Selling his interest to an outside person. Asking the other partners to buy him out. Asking the partners to distribute some partnership assets to him in exchange for his interest in the business. Discuss the tax issues associated with each of the alternatives Sam is proposing. Which do you think is the best alternative for Sam and his partners?

Answer 1

If the outgoing partner remains in partnership for more than 1 year, the gain so made will be regarded as long term capital gain.

On the other hand, in case if the other partners buys the outgoing partner share, it tax provisions will be similar as above. The amount so received as sales proceeds will be used as the basis and the outgoing partner’s tax basis in partnership will be deducted from the same to arrive at the taxable income.

If the partners agree to distribute the partnership asset to the outgoing partner, then in this case, the tax basis of the outgoing partner will be deducted from the value of the asset received. This will determine the gain and loss to the outgoing partner. (IRS 761_Taxation of partnership)

In the given case Sam, one of the 4 partners in the partnership decides to move out of the partnership, he has been asked either to the sell his share to some outside person or to the partners or can take assets from the partnership. In light to the above provisions, Sam will be liable for all taxation the partnership is not liable for any taxation. In all the three case, Sam’s tax basis in the partnership will be deducted from the sales proceeds from the outside person or from other person or from the value of the asset so received. The balance will be either being a taxable gain or loss.

From the perspective of Sam and other partners, the second options of selling the share to the other partners are better. It is not from tax perspective but from the perspective of control.