Distributions to retiring partners.

• Author: Jamison, Robert W.
• Position: Part 1

RRA Changes to Partnership Rules and Amortization of Goodwill Create Complex Tax Problems

The Revenue Reconciliation Act of 1993 (RRA) modified the tax treatment of distributions to retiring or deceased partners under Sec. 736. At first glance, these provisions appear to be of relatively minor importance, but as Part I of this article will illustrate, they may have a significant effect on tax planning for Sec. 736 distributions.

The RRA also adopted uniform amortization rules for intangible assets. These rules have broad applicability; they are not limited to transactions between partnerships and partners, but do have some special ramifications for distributions to retiring or deceased partners. Part II of this article, to be published in May, will explore the most important aspects of the amortization provisions as they relate to distributions to retiring or deceased partners.

Overview of Sec. 736

Sec. 736 governs the treatment of liquidating payments made by a partnership to a retiring or deceased partner or the successor in interest of the deceased partner. Although either cash or property may be used to make these payments, most are made in cash. Throughout this article, it is assumed that the payments will be made solely in cash.

Sec. 736 separates liquidating payments into two classes: Sec. 736(b) payments, made in exchange for the retiring or deceased partner's interest in partnership property, and Sec. 736(a) payments not in exchange for the partner's interest in partnership property.

A special rule applies to payments in exchange for the distribute partner's interest in two specific types of partnership property. Under pre-RRA law, payments in exchange for the partner's interest in unrealized receivables and unstated goodwill were always treated as Sec. 736(a) payments (rather than Sec. 736(b) payments).(1) In essence, such payments were treated as not being in exchange for partnership property. Unstated goodwill is goodwill that is not provided for in the partnership agreement and does not have an existing basis on the partnership tax books. For Sec. 736 purposes, the prior law definition of unrealized receivables included not only cash-basis receivables, but also depreciation recapture and other miscellaneous provisions defined in Sec. 751(c).

Under the RRA, distributions in exchange for the distributee's share of certain types of previously defined unrealized receivables will no longer be classified as Sec. 736(a) payments. Similarly, distributions in exchange for the distributee's share of all receivables and goodwill in many partnerships will also be classified as Sec. 736(b) payments. These law changes will be discussed in more detail later.

Once the amount of the Sec. 736(b) payments has been determined, these payments are taxed under Secs. 731, 732, 733 and 75l(b). The Sec. 751(b) component of the distribution should be calculated first, and results in the distributee partner recognizing ordinary income to the extent that the partner receives cash in exchange for his share of certain ordinary income-producing assets (as defined in Sec. 751) held by the partnership.

The remaining Sec. 736(b) distribution is treated as a return of the distributee partner's basis for his partnership interest. If this distribution is less than the partner's adjusted basis in the partnership, the partner recognizes a capital loss; if it exceeds the partner's adjusted basis for his partnership interest, the excess amount is taxed to the distributee partner as a capital gain.

While the amount of Sec. 736(b) payments can be specifically determined under the statute, the amount of Sec. 736(a) payments is merely the excess of the total Sec. 736 payments over the amount of the Sec. 736(b) payments. Sec. 736(a) payments are taxed to the distributee partner a either a distributive share of income or a guaranteed payment. Such payments are taxed as a distributive share if they are determined by reference to partnership income. The recipient partner receives a K-1, which contains the type(s) and amount(s) of partnership income being allocate to the partner. Sec. 736(a) distributive share payments are taxed to the distributee partner according to the character of the income earned by the partnership and passed to the partner on the K-1 Because the income is taxed to the retiring partner or a deceased partner's successor under Sec. 736(a), it is omitted from the K-1s of the continuing partners, thereby giving the continuing part ners the effect of a deduction for these items.

Sec. 736(a) payments are taxed to the distributee partner as guaranteed payments if the amount of the payments is determined without reference to partnership income, e.g., payments that are stated in a specific dollar amount or calculated as a percentage of gross sales. Such payments are deductible by the partnership and are taxed as ordinary income to the distributee partner.

Tax Planning Under Pre-RRA Law

Before the RRA's passage, Sec. 736 provided considerable flexibility in planning a liquidating distribution. In the typical situation, the continuing partners in the partnership were higher bracket taxpayers, while the retiring partner was dropping down into a lower marginal tax bracket. The partnership would usually negotiate for a larger amount of the payments to be classified under Sec. 736(a) and for a smaller amount of the payments to be classified under Sec. 736(b). If, for example, most of the Sec. 736(a) payments were guaranteed payments, the partnership and, therefore, the higher-bracket continuing partners would be able to deduct these payments. While the retiring partner should, theoretically, prefer Sec. 736(b) payments, many retiring partners were willing to give up Sec. 736(b) treatment for a larger total distribution that would then be taxed at the retiring partner's lower marginal tax bracket. Often, the net effect of this planning was to provide both the continuing partners and the retiring partner with more after-tax dollars and the Treasury with lower tax receipts from both parties.

The negotiated result was usually supportable under the pre-RRA Code and regulations. Sec. 736(b)(2) provided that payments made by the partnership to the retiring or deceased partner's successor for that partner's share of partnership unrealized receivables (as defined in Sec. 751(c)) and goodwill (except to the extent provided for in the partnership agreement) were to be treated as Sec. 736(a) payments. Therefore, if the negotiations provided that the payments were primarily for unrealized receivables (which included recapture potential under Secs. 1245 and 1250) and "unstated" goodwill, the amount of the Sec. 736(b) payments could be minimized.

The RRA changes are not so extensive as to eliminate the tax...