When a partner withdraws from a partnership, it usually does not matter to the principals whether the withdrawing partner receives compensation for his partnership interest from third parties, from the partnership, or from the remaining partners themselves. After all, there is generally little, if any, actual economic difference between the liquidation of a partner’s interest and a sale of that interest. However, the differences in tax consequences between a sale and liquidation can be quite significant.
In many cases, structuring a partner’s withdrawal as a liquidation will provide more favorable tax treatment than if it is structured as a sale to the remaining partners. This is particularly the case for partners who derive no significant benefit from having their gains classified as capital gains.
The underlying reason for this disparity is that sale or liquidation payments are taxed according to the types of partnership property to which they are attributable.
Consider the taxation of payments for unrealized receivables. In a liquidation, these payments will be taxed as ordinary income to the distributee (departing partner) under Section 736(a) of the Code, and the remaining partners will receive ordinary deductions. However, if the transaction is instead structured as a sale, the departing partner will still have ordinary income under Section 751(a), but the remaining partners will receive no deduction. (If a Section 754 election is in effect, the remaining partners will of course obtain a basis step-up, which will reduce their ultimate taxes.)
If any of the payments to the departing partner are attributable to inventory, it would also generally be preferable to structure the transaction as a liquidation rather than as a sale. If the partnership’s inventory is appreciated, that partner will have ordinary income on a sale but not upon liquidation. (In the case of “substantially appreciated” partnership inventory, the departing partner will have ordinary income regardless of whether the transaction is a sale or liquidation.) Furthermore, whereas the remaining partners will receive a cost basis for the departing partner’s share of the inventory if the transaction is a liquidation, the remaining partners in the case of a transaction structured as a sale will be able to increase their basis only if a Section 754 election is in effect.
In a liquidation, moreover, payments for unstated goodwill will generate ordinary income to the departing partner and ordinary deductions for the remaining partners. In a sale, by contrast, any payment received upon a purchase of a partnership interest that is attributable to partnership goodwill is generally treated as capital gain and is not deductible by the remaining partners.
The collateral consequences of a liquidation also often tend to be more favorable than the collateral consequences of a sale. Under Section 708(b)(1)(B), a sale will terminate a partnership’s existence if the departing partner holds a 50-percent or greater interest in the partnership. The termination of a partnership not only creates administrative hassles, but will also give rise to certain constructive transactions that may have undesirable tax results. By contrast, a liquidation of a partner’s interest in the partnership will not cause such a termination, even if the partner has a 50-percent or greater interest in the partnership.
It should be noted that several seemingly ancillary tax factors can alter the analysis in choosing between sale and liquidation treatment. Additionally, careful planning and draftsmanship are crucial to distinguish a transaction as a liquidation or sale because a partnership’s mere choice of form for the transaction.