Question

Dad owns a 60% interest in the Consulting Services Partnership in which capital is not a material income producing factor. Two other unrelated partners each own 20% of the partnership.

His son, Bill, worked for the partnership on a part-time basis while in college and has shown a strong aptitude for the business. Dad wants to retire but needs to cash in his partnership interest for its $850,000 value as soon as possible in order to do so. He wants Bill to take over as majority owner of the partnership when he retires. Dad’s basis in the partnership is $300,000. His share of the partnership’s unrealized receivables is $200,000 (Basis $0).

The partnership has a favorable tax year-end, so the other partners don’t want the partnership to terminate. The partnership can distribute $850,000 cash to buy out Dad’s interest immediately. Bill is the beneficiary of a trust fund established by his grandmother. He receives about $80,000 a year and will vest in the $900,000 principal amount in 4 years, when he reaches age 30.

Dad is considering two courses of action:
               a. He can sell his interest to Bill on an installment basis with a balloon payment at the end of 4 years. In this case, the entire 60% interest is deemed sold for tax purposes at the same time the installment contract is consummated (although gain is deferred until payments are received).

               b. He can allow the partnership to redeem his partnership interest. In this case the partnership will enter into an employment agreement with Bill, whereby he vests in a 10% interest in the partnership each year for 6 years in exchange for services rendered to the partnership.

Answer 1

There are two course of action in front of Dad as mentioned in the case study, these are as following;

Firstly, Dad can sell his interest in the partnership on an instalment basis. The sale will result in payment of large proportion of sale consideration at the end of 4 years. However, for tax purposes it would be considered as a sale of entire 60% interest of Dad in the partnership at the time when the instalment contract is consummated even though the gain on sale is deferred till the end of 4^th year when the payments will be received. Thus, in case Dad enters into the contract of instalment sales the whole amount of sale proceeds will be subjected to tax in the year in which the instalment contract is consummated. Thus, the option of instalment sales is not tax effective for the sale of partnership interest of Dad.

Second option allows Dad to redeem his interests in the partnership. The partnership will enter into an employment contract with Bill to vest 10% interests in the partnership each year for next 6 years to count for the entire 60% interest of Dada in the partnership in exchange of services to be rendered to the partnership. Thus, the second option is tax effective to Dad as he will receive entire amount of his for the sale his interest in the partnership and with the payment made in lieu of services to be rendered hence, the tax liability will be minimum for sale of the interest in the partnership.        

Thus, Dad shall chose the second option of allowing the partnership to redeem his partnership interests.