A partner may dispose of an interest through a sale, exchange, withdrawal, retirement, or at death. The tax result depends on the type of assets inside the partnership and whether the partner is relieved of liabilities.
Sale or Exchange of a Partnership Interest
The sale or exchange of a partnership interest generally produces capital gain or loss. The gain or loss equals:
The amount realized includes:
- Cash received
- Fair market value of property received
- Relief of partnership liabilities, which is treated as money received
If the partner is relieved of liabilities, that relief increases the amount realized.
If the partnership has no hot assets, the entire gain or loss is capital.
Payments for Unrealized Receivables and Inventory
When a partner transfers an interest, the portion of the payment attributable to unrealized receivables or inventory items is treated as ordinary income. These assets are Section 751 hot assets.
The ordinary portion equals the partner’s share of ordinary income that would have been recognized if the partnership had sold all hot assets at fair market value immediately before the transfer.
The remaining gain or loss is capital.
Retirement or Death of a Partner
Payments to a retiring partner or to the successor of a deceased partner fall into two categories:
- Payments for partnership property
These are treated as distributions, not guaranteed payments. They reduce outside basis and may trigger gain only if money received exceeds basis.
- Payments not for partnership property
These are treated as a distributive share of income or guaranteed payments, depending on the agreement.
A retiring or deceased partner’s successor is treated as a partner until the interest is fully liquidated.
Inventory received in a liquidation and sold within five years produces ordinary income or loss, not capital gain or loss.
Gain Recognition in Liquidation
A partner recognizes gain only when money received exceeds outside basis. Loss is recognized only when:
- The partner’s entire interest is liquidated
- The partner receives only money, unrealized receivables, or inventory
- No other property is received
If any other property is received, loss is not allowed.
Summary
- Sale of a partnership interest → generally capital gain or loss
- Liability relief increases amount realized
- Section 751 hot assets create ordinary income
- Retirement and death payments may be distributions or guaranteed payments
- Loss in liquidation allowed only with money, unrealized receivables, and inventory