The Termination of a Partnership Structure: Should you Liquidate or Sell?

Business Tax

There may be many ways to skin a cat, but when it comes to the termination of a partnership interest, we are aware of two possible considerations.

In many cases, the tax consequences are the most critical considerations as the economic results of a liquidation or a sale are quite similar in nature. We thought we would share our experiences with the termination of a partnership structure. Our considerations centered around a decision to make a complete liquidation or consider a sale/exchange transaction of that partnership interest. In a liquidation, the partnership itself, and not a new or existing partner, make the payments to the departing partner. Our decisions provided here share with you some of the differences between a liquidation of a partner’s interest by the partnership versus a sale of the interest to another partner or partners.

Liquidation payments made by the partnership are treated as payments for amounts received and do not generate a deduction for the partnership. These payments to the departing partner constitute a long-term capital gain, if they exceed his basis in the partnership. It may also be possible for the partnership to make payments to the departing partner for certain assets that can be deductible as guaranteed payments for the partnership but are considered ordinary income to the departing partner. It must be determined what types of assets the departing partner is giving up to make this determination.

In the case of a service partnership, a liquidation of a general partner’s interest can produce dramatically different results than a sale of the interest to another partner, where there are payments for such items as goodwill that is not provided for in the partnership agreement. A purchase of a partner’s interest by another partner generally results in long-term capital gain to the selling partner for certain assets sold. However, the redemption of the selling partner’s interest by the partnership generally results in ordinary income to the selling partner and an up-front ordinary deduction to the partnership.

A partner who sells their partnership interest is taxed on the resulting gain at a maximum rate of 25% to the extent the gain is attributable to depreciation on real estate owned by the partnership.

In a liquidation, if both partners agree, buyer and seller, the departing partner recognizes no gain until he recovers the entire basis in his interest. Unlike a sale of a partnership interest, a deferral can be achieved by using the installment sale method and only a portion of the gain would be recognized each year to the extent of payments received.

A sale of 50% or move of partnership profits and capital interest within a 12 month period causes a termination of the partnership. A liquidation does not cause a termination of the partnership.

Thus, there are many aspects to consider when making a decision to sell your partnership interest. We suggest that you contact your business advisor prior to any entering into any sale agreement.

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