When a partner exits a partnership - whether by retirement, death, or buyout - the tax treatment of the payments received depends on a classification that most partners and many advisors do not fully understand: the §736 divide. Payments for the partner's share of partnership property (§736(b)) are treated as liquidating distributions - generally capital gain or return of basis. Payments for anything else - goodwill in most cases, and future partnership earnings - are §736(a) payments treated as ordinary income. Getting this right can be the difference between a 20% and a 37% tax rate on the same economic payment.
§736(b) - Payments for property interest: Treated as a distribution in exchange for the partner's interest in partnership property. Results in capital gain (or loss) to the extent the payment exceeds (or is below) the partner's outside basis in the partnership interest. No deduction for the partnership.
§736(a) - Everything else: Treated as a distributive share of partnership income (if determined by partnership income) or as a guaranteed payment (if fixed amount). Both are ordinary income to the recipient. The partnership deducts guaranteed payments; distributive shares reduce other partners' income.
The critical question: What falls into §736(a)? Primarily: (1) payments for goodwill unless the partnership agreement specifically provides for goodwill payments; (2) payments for unrealized receivables; and (3) payments for future income participation.
Before applying §736, the §751 hot asset rules require ordinary income recognition on the departing partner's share of "hot assets" - unrealized receivables and substantially appreciated inventory. A partnership with significant accounts receivable (for cash-basis partnerships), depreciation recapture potential, and other ordinary income items must first allocate the appropriate share of that ordinary income to the departing partner before the §736 analysis applies to the remaining consideration.
The §751 hot asset computation is done on Form 8308 (if a publicly traded partnership) and disclosed on the K-1. For small service partnerships - law firms, accounting firms, consulting practices - the accounts receivable are almost always the largest hot asset. A law firm partner receiving a buyout must recognize their share of the firm's uncollected receivables as ordinary income, regardless of how the buyout agreement characterizes the payment.
The treatment of goodwill payments in a partnership liquidation turns on whether the partnership agreement specifically provides for goodwill payments. If the agreement is silent on goodwill, payments for goodwill are §736(a) payments - ordinary income to the retiring partner, deductible by the partnership. If the agreement specifically provides for goodwill payments to a retiring partner, those payments are §736(b) - treated as payments for a capital asset, resulting in capital gain.
This creates a significant planning opportunity. A well-drafted partnership agreement that specifically provides for goodwill payments converts what would be ordinary income to the retiring partner (and a deduction for the remaining partners) into capital gain for the retiree (with no deduction). Whether to include a goodwill provision depends on the relative tax positions of the retiring and remaining partners - the retiree wants capital gain treatment; the remaining partners want the deduction. Negotiating this provision is a tax planning decision with significant implications for both sides.
Liquidating payments to a retiring partner paid over time may qualify for installment sale reporting under §453. §736(b) payments qualify for installment treatment - the capital gain is deferred to the years of actual receipt. §736(a) payments (guaranteed payments) are ordinary income in the year the partner is entitled to them, regardless of when actually received - no installment deferral available for §736(a).