Reassessing Sales and Liquidations of Partnership Interests after the Omnibus Budget Reconciliation Act of 1993

Abstract

Subchapter K of the Internal Revenue Code has historically afforded considerable flexibility in determining the federal income tax consequences of the retirement or withdrawal of a partner from a partnership. In general, the departure of a partner can be structured either as a purchase of the retiring partner's interest by the remaining partners or as a liquidation of the partner's interest by the partnership. Although these two transactions are essentially similar in economic consequences, they have been governed by two separate sets of provisions in Subchapter K, often resulting in significantly different tax consequences. The sale of a partner's interest is governed primarily by sections 741 and 751(a), whereas the liquidation of a partner's interest by the partnership is governed primarily by section 736.
Under sections 741 and 751(a), the sale of a partnership interest generates capital gain or loss to the selling partner, except to the extent that he or she is being compensated for an interest in certain ordinary income items of the partnership-namely, its unrealized receivables and substantially appreciated inventory. The purchasing partners receive few, if any, immediate tax benefits. Under section 736, by contrast, the liquidation of a partner's interest by a partnership could result in significant immediate tax benefits to the remaining partners. Specifically, under section 736(a), certain payments for a retiring partner's share of the partnership's good will and unrealized receivables would give rise to an immediate deduction or its equivalent for the remaining partners and usually result in ordinary income to the retiring partner. Payments for the partner's share of other partnership property would be treated under section 736(b) as a distribution from the partnership to the partner, resulting in no deduction for the remaining partners and, for the most part, generating capital gain or loss for the retiring partner.