Deductible payments to departing partners - the RRA and its impact on LLCs.

• Author: Kurtz, N. Patricia
• Position: Revenue Reconciliation Act of 1993, limited liability companies

Prior to the Revenue Reconciliation Act of 1993 (RRA), a partnership had great latitude in structuring payments to a retiring or deceased partner to maximize the combined tax benefits to both parties. The partnership and departing partner were free to determine whether the transaction was to be treated as a purchase of the partner's interest by the remaining partners under Sec. 736(b)(1) (generally resulting in capital gain or loss to the departing partner) or as a liquidating distribution under Sec. 736(a) (generally resulting in the payments being taxed as ordinary income to the departing partner and being deductible by the partnership). The courts have generally held that the parties in such situations are free to structure the transaction either as a sale or a liquidation of the departing partner's interest.

The RRA modified Sec. 736(b) by severely limiting the ability of a partnership to structure deductible payments to a retiring or deceased partner. These new restrictions generally apply to partnerships in which capital is a material income-producing factor or to payments made to other than a general partner. It appears that this latter restriction may have unintended negative consequences for certain limited liability companies.

Sec. 736 treatment - prior

law

The special rules governing the treatment of payments made in redemption of a retiring or deceased partner's partnership interest are found in Sec. 736, which divides these distributions into two categories: (1) Distributions made in exchange for a partner's interest in partnership assets; and (2) distributions made not in exchange for partnership assets, but rather as allocations of partnership net income or as guaranteed payments.

Liquidating payments made in exchange for partnership property are treated as distributions by the partnership under Sec. 736(b), and generally result in gain to the retiring partner only to the extent the cash distributed exceeds the partner's adjusted basis in his partnership interest. This gain is considered capital gain unless a portion of the payment is attributable to the departing partner's share of the partnership's substantially appreciated inventory or unrealized receivables (as defined under Sec. 751). Such a payment is not deductible by the partnership or by the remaining partners.

An exception to Sec. 736(b) treats amounts paid for goodwill and unrealized receivable of the partnership as not being made in exchange for an interest in...