Death Or Retirement Of A Partner

Once upon a time there were three lawyers. Over lunch they agreed to merge their individual practices and form a partnership. Through the years, the practice thrived and 15 years later the practice had 25 partners, 65 associates and several floors in a Century City high rise. One of the original partners, John, had recently gone through a nasty divorce, his third. The divorce and several years of therapy convinced him that he had enough of the long hours, unending lawyer jokes and constant pressure. Upon consultation with his two original partners, John formally announces to the partnership that he is leaving at the end of the year.

Bob, the firms managing partner, is given the assignment to work out the financial details of Johns departure. The partnership agreement provides that a departing partner is to be paid his accrual basis capital account and an average of his last three years income. The partnership agreement is silent as to the nature of the payments. Payment of the capital account is to be paid in 12 equal monthly payments. Upon the completion of the capital account pay out, the remaining obligation is to be paid over 60 months.

In a meeting with the firms tax accountant, Bob casually mentions that John is leaving at the end of the year. He inquires as to how the firm is to account for the payments to John. The accountant, who specializes in personal service entities, responds in the only way he knows. He pulls out his pocket version of the Internal Revenue Code (IRC). The result of the conversation adds a great deal of complexity to a transaction Bob believed to be quite simple.

The Real Story
The general rules covering either the retirement or death of a partner are found under Section 736 of the IRC. In order to meet the requirements of Section 736, there must be a complete termination of the partners interest. Even if state law provides that the taxpayer is no longer a partner, for tax purposes, the departing partner is still considered a partner until all payments are made in liquidation of the partners interest.

Payments made to departing partners are characterized as either payment for the partners distributive share of the partnership income, interest in the partnership assets or as a guaranteed payment. Obviously the characterization of each of these will result in differing tax reporting and tax treatment for the departing partner and the partnership.

Under Section 736, payments for the departing partners interest in the partnership assets do not include payments for uncollected accounts receivable. Additionally, payments will not be considered as made for the partnerships goodwill unless the partnership agreement specifically provides for such type of payment.

Section 736 provides flexibility not offered by many other IRC sections that both John and the partnership can take advantage of.
Capital gains treatment can be afforded the departing partner if the payments can be characterized as payments for goodwill.
If the partner has carryover capital losses, the receipt of payments for goodwill could be tax-free.
If the payments are designated as goodwill, the partnership would be required to capitalize the payments and amortize them over 15 years.
In order to receive capital gain treatment, the partnership agreement would have to provide for goodwill payments.

Generally, the Internal Revenue Service will accept the characterization of payments, however, they are not obligated to do so. Therefore, valuations of partnership property should be reasonable. If the partnership or other agreements do not allocate a payment to a specific item, the payments will be allocated to the different categories. Therefore, a portion of each payment will be allocated to partnership interests, unrealized receivables and possibly goodwill.

There are many methods of dealing with a partners departure, which can result in vastly differing tax treatments, and timing of income and deductions. Some of these methods include:

Remaining partners could individually purchase the partners interest.
New partners entering the partnership can individually acquire the departing partners interest.
The entire partnership could liquidate, and the assets and liabilities could be distributed to the partners.
Ensuring a Happy Ending
Whichever method is selected, careful tax planning is required in order to accomplish the goals of the departing partner and the partnership. Remember, what may be favorable to the departing partners may not result in the best tax treatment for the partnership.
There are a number of other areas to evaluate in connection with the tax treatment resulting from a departing partner. Seek professional tax advice to determine the most advantageous tax treatment for the departing partner as well as the partnerships.
RBZ, LLP is a full service public accounting firm. For more information about the services we provide, visit www.rbz.com.