Are payments made from a partnership to a retiring partner ordinary income or capital gains?
Taxpayer Says: The payments were made in exchange for an interest in the partnership and should be taxed as long-term capital gains.
Internal Revenue Service Says: The distributions are guaranteed payments and should be taxed as ordinary income.
From Internal Revenue Code Section 736(a)(1), 736(a)(2), 736(b): Payments made by a partnership in liquidation of the interest of a retired partner are divided into three categories; (1) those representing the recipient’s distributive share of partnership income, (2) those deemed to be guaranteed payments, and (3) those in exchange for the partner’s interest in partnership property.
From Revenue Ruling 75-154: Periodic payments made in satisfaction of a partnership liability to a previously retired partner, in addition to amounts previously paid to the retired partner for his interest in partnership property, are guaranteed payments because they are determined without regard to the income of the partnership.
THE CAUSE OF THE DISPUTE
When you retire from a partnership, you may receive payments that include your share of the partnership’s income or loss from operations, payments made to you for the use of your capital without regard to the partnership’s income or loss (guaranteed payments) and payments for your interest in the partnership.
Guaranteed payments and your share of the partnership’s income or loss are treated as ordinary income, and are taxed at ordinary income rates according to your marginal tax bracket. Payments you receive for your partnership interest can either be a nontaxable return of your investment or a capital gain, taxed at more favorable capital gains rates.
In this case, a retiring partner received cash distributions in liquidation of his partnership interest. Included in the payments were amounts for ‘units’ he had been awarded during his years with the partnership. Partners received 50 of the units each year for services rendered to the partnership regardless of the size of their partnership interest and without regard to the partnership’s income. Partners received no payment for the units at the time of distribution. Instead, partners received the value of the units over a certain time period upon retirement.
The taxpayer says the partnership agreement states the value of a partner’s interest in the partnership is the sum of the partner’s capital account and the units. The taxpayer believes that definition means the payments for his units were made in exchange for his interest in the partnership, and they should be taxed as long-term capital gains.
The IRS says the partnership agreement does not define the units as partnership property, so payments for them do not constitute a return of capital. In addition, since the units were granted without regard to the partnership’s income, distributions based on their value are guaranteed payments and should be taxed as ordinary income.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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