Question

Andrew and Beth are equal partners in the AB Partnership. On December 30 of the current year, the AB Partnership agrees to liquidate Andrew’s partnership interest for a cash payment on December 30 of each of the next five years. What tax issues should Andrew and Beth consider with respect to the liquidation of Andrew’s partnership interest?

Answer 1

In pursuance to AB Partnership decision to liquidate Andrew’s partnership interest for a cash payment following are the tax issues that Andrew and Beth should consider with respect to the liquidation of Andrew’s partnership interest –

• If the total amount of cash distributed is more than a Andrew’s share in the partnership interest, the difference in the two amounts is a gain. A loss results when the liquidating distribution is less than the Andrew's share in the partnership. Partners, however, can only take a loss on their returns if it's solely the result of a liquidating distribution of cash .
• Section 736 applies to payments made by the partnership to a retiring partner or to a deceased partner’s successor in interest in liquidation of the partner’s entire interest in the partnership.
• Payments made for a partner’s share of the inventory of the partnership are treated as Section 736(b) payments, Payments made to a partner under Section 736(b) are taxed under the distribution rules of Section 731. Thus, payments made to a partner that are treated as Section 736(b) payments generate capital gain to the extent they exceed the partner’s basis in the partnership interest. The partnership receives no tax deduction for Section 736(b) payments because the payments represent a purchase of the retiring partner’s capital interest.
• Section 736(a) payments include all payments made to a retiring partner that are not Section 736(b) payments, like in this case. Thus, if a partnership makes payments to a general partner in a service partnership, payments made for the partner’s unrealized receivables and un-bargained for goodwill are treated as Section 736(a) payments. Section 736(a) payments are taxed as guaranteed payments to a partner if the payments are determined without regard to partnership income. If the payments are treated as guaranteed payments, the partnership receives a deduction for the guaranteed payment. In turn, the partner must report the income as ordinary income for the partner’s year with or within which ends the partnership’s tax year in which the partnership deducts the payment. The payment is included in the partner’s self-employment income. If the payments are treated as the partner’s distributive share, the partnership does not receive a deduction for the payments, but because the payment is treated as a special allocation of income to the retiring partner, the allocation reduces the income otherwise available to be allocated to the remaining partners. If the partner’s distributive share of partnership income would otherwise be included in the partner’s self-employment income, any payment under Section 736(a) that is treated as a distributive share would also be included in the partner’s self-employment income.

Liquidating payments that are not Sec. 736(a) payments are Sec. 736(b) payments and are considered non deductible distributions of partnership property. These payments generally receive capital gain treatment for the liquidating partner. Liquidation may be accomplished using deferred payments. These deferred payments are not taxed to the liquidating partner until the payments received exceed his or her outside basis