Partner's payments on dissolution of law firm were ordinary income.

• Author: Fiore, Nicholas J.

T and L were the senior partners in the T law firm, from 1971 until 1976; during this time there was no written partnership agreement. In April 1976, L convened all the other partners and they voted to dissolve the T firm, and announced the formation of the L firm. Legal action followed; ultimately an agreement was reached under which T would receive installment payments for his share of the T firm's unrealized receivables and a lump sum for his interest in the T firm's fixed assets and goodwill.

In 1983 and 1984, T reported the installment payments as resulting from the sale of his T interest, giving rise to long-term capital gain and claiming capital gain deductions. The IRS disallowed the deductions, arguing that the payments were in liquidation of his T firm interest and gave rise to ordinary income. In a memorandum decision, the Tax Court (opinion Halpern, J.) agrees with the Service.

Sale vs. liquidation

The tax consequences of the sale of a partnership interest may differ significantly from those of a liquidation of that interest. That is so even though the economic consequences of those alternatives may be indistinguishable under certain circumstances. For example, when a partner retires, it generally makes little or no economic difference either to him or to the continuing partners whether his interest is purchased pro rata by the continuing partners or liquidated in exchange for payments from the partnership. In either case, the continuing partners ultimately bear the cost of acquiring the interest and their interests in the partnership are increased proportionately. When faced with such a situation, it is clear that the partners have complete flexibility to structure the transaction as either a Sec. 741 sale of the withdrawing partner's interest to the other partners or a Sec. 736 liquidation of the retiring partner's interest by the partnership.

It must be kept in mind, however, that the flexibility that is permitted is not a license to determine the tax result simply by checking a box on the tax return. The permitted flexibility is the flexibility to structure the transaction as either a sale or a liquidation. A transaction properly structured as a sale or liquidation will be taxed accordingly.

Continuation of the partnership business following dissolution of the partnership

The dissolution of a partnership no more terminates the partnership for federal income tax purposes than it does for state law purposes. On dissolution the...