Payments to Retiring Partners: Section 736 and Related Problems

• Pages: 249-270
• Author: James R. Repetti,William H. Lyons,Charlene D. Luke

249

Chapter Thirteen

PAYMENTS TO RETIRING PARTNERS:

SECTION 736 AND RELATED PROBLEMS

A. Introduction

We saw in Chapters 9 and 11 that a partnership makes several

different types of payments to partners. Some of these payments are

non-liquidating distributions of the partner’s distributive share of

income or liquidating distributions to which § 731 and § 751(b) apply.

Other partnership transfers are not distribution s becau se they

constitute payments to rent, purchase, or borrow property from a

partner or to compensate the partner for services rendered by that

partner in a non-partner capacity. § 707(a). Guaranteed payments to

a partner, which are governed by § 707(c), also are no t treated as

“pure” distributions but instead receive a hybrid treatment.

1

These kinds of “non-distribution” transfers may be hard to

identify in particular cases, but once they have been identified there

is little danger that an advisor will app ly the incorrect Code section.

Nobody, for instance, would apply § 731 and § 751(b), which relate to

distributions, to a payment of market-rate rent on property leased by

a partner to a partnership. Sometimes, however, § 736 classifies

payments to partners as something other than “distributions” even

though the payments would otherwise qualify as distributions.

Section 736 applies to payments to “retiring partners.” The term

is somewhat misleading. A retiring partner is not necessarily a senior

citizen. Regulations define a retiring partner as any partner who is

leaving the p artnership. Reg. § 1.736–1(a)(1)(ii). Someone who has

been expelled from a partnership or who has been persuaded to

withdraw in exchange for a payment is as much a “retiring partner”

as someon e who gets a gold watch and a dinn er. (Section 736 also

applies to payments made in liquidation of the interest of a deceased

partner, which raises additional issues discussed in Chapter 15.)

To begin our exploration of how § 736 may characterize

payments to a retiring partner, suppose a partner withdraws from a

partnership and receives from the partnership $70,000 in cash and a

1

As discussed in Chapter 9, guaranteed payments are similar to a distributive

share in that they are included in the partner’s income when the partnership accounts

for the guaranteed payment by deducting or capitalizing the payment, not when the

partner receives it. Reg. § 1.707–1(c). Guaranteed payments, however, differ from

distributions in that the receipt of a guaranteed payment has no effect on the

recipient’s outside basis or capital account. Reg. § 1.704–1(b)(2)(iv)(o).

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Payments to Retiring Partners:

Section 736 and Related Problems

Ch. 13

$30,000 constructive cash distribution under § 752(b).

2

In everyday

speech, this $ 100,000 payment is a liquidating distribution because

the distribution is being made to terminate the partner’s interest in

the partnership.

3

For tax purposes, however, because the payment is

to a retiring partner, § 736 applies first, and it may characterize some

or all of the payment as something other than a liquidating

distribution. More spe cifically, § 736 may treat th e payment as a

current distribution of the partner’s distributive share of partnership

income, as a guaranteed payment, or as a liquidating distribution.

4

It is helpful to review briefly the implications of each such

characterization. If the payment to a retiring partner i s

characterized as a current distribution of the partner’s distributive

share of partnership income, the partnership allocates income to the

retiring partner and then distributes that income to her. The

allocation causes the retiring partner to recognize inco me from the

allocation that has the same character as the partnership’s income.

5

Her actual receipt of the allocated amount does not result in any

additional income recognition because her outside basis increased by

the allocated income. § 705(a)(1); § 731(a)(1). In addition, the other

partners do not include in their shares of partnership income the

retiring partner’s distributive share of income.

If the payment is treated as a guaranteed payment, the retiring

partner recognizes ordinary income, and the partnership deducts the

payment unless it is a capital expenditure.

6

If, ins tead, the payment is characterized as a liquidating

distribution, the retiring partner may, depending on her outside

basis, recognize gain or loss under § 731, § 751(b) may apply, and the

partnership will not deduct the payment.

7

2

It is important to remember that reductions in a partner’s share of partnership

debt are treated as cash distributions under § 752(b). Chapter 3 § B and Chapter 8.

As a result, partners withdrawing from a partnership that has debt will usually

experience constructive cash distributions under § 752(b).

3

See Chapter 11 § A.1.

4

Reg. § 1.736–1(a)(3) and (b)(1).

5

If the allocated income is capital gain, the 20% deduction under § 199A will

not be available because capital gains are not qualified business income.

§ 199A(c)(3)(B). Items of ordinary income allocated to a partner, however, may qualify

for the 20% deduction if all the requirements of § 199A are met. See Chapter 1 note 13

for an overview of § 199A; see Chapter 9 § A for a discussion of some aspects o f the

application of § 199A to partners’ distributive shares.

6

See Reg. § 1.736–1(a)(4). As discussed in Chapter 9 § A, guaranteed payments

for “services rendered” are not treated as qualified business income eligible for the

20% deduction under § 199A. § 199A(c)(4)(B). As we will discuss in more detail below

in note 15, it is not entirely clear whether p ayments that are characterized as

guaranteed payments under § 736(a) are for “services rendered.”

7

See Chapter 11 §§ A.1, B.1, and B.2 for the treatment of liquidating

distributions. Some of the gains recognized by the retiring partner may be capital

gains. As discussed in note 5, above, capital gains are not treated as qualified business