Termination of a partnership interest.

AuthorDulworth, Cynthia L.

This item explores the two main methods used when terminating a partnership interest: purchase and liquidation. A terminating partner may sell his or her interest to one or more of the remaining partners, or the partnership may liquidate his or her interest. The tax issues associated with these two methods, such as whether the change generates ordinary income or ordinary deductions or capital gain treatment for the partnership and for the terminating partner, should be considered in detail. How the partnership treats the termination is important to both parties in order to receive the tax treatment intended.

Purchase of a Partner's Interest

Under the purchase scenario, one or more remaining partners may buy out the terminating partner's interest for fair market value (FMV) plus any relief of debt realized by the partner. If the FMV of the partnership assets is greater than their associated tax basis, it is usually advantageous for the partnership to make a Sec. 754 election to step up the basis of the assets under Secs. 734(b) and 743(b). However, once the partnership makes the election, it stays in effect for any subsequent sale until the partnership requests the election to be rescinded. The acquiring partners' incremental change in ownership now has a basis equal to FMV.

The Sec. 754 election must be applied to each asset of the partnership. The difference between the FMV and the tax basis of each asset determines whether the asset will receive a step-up or a step-down. If the partnership elects Sec. 754 treatment, any assets that have declined in value must be stepped down, just as the appreciated assets will be stepped up. There is no picking or choosing which assets are to be considered. Also, if a subsequent buyout of a partnership interest is below FMV, then the step-down rules must also apply under this election.

The benefit of this election is that the acquiring partners are allowed to take additional deductions as the assets that generated the step-up are disposed of or depreciated. Likewise, if there is a step-down, the book deduction will be reduced. In theory, if all the assets were disposed of, the acquiring partner's interest would end up back at book basis.

Without the Sec. 754 election, the incremental value of the partnership interest purchased will stay on the acquiring partners' books until the partnership interest is terminated. The Sec. 754 election will create additional accounting work to maintain the two sets of...

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