Tax Consequences of Adding or Removing a Partner from an Existing Partnership

Admitting a New Partner for a Contribution

When a new partner contributes money or property in exchange for a partnership interest, §721 generally provides that neither the partnership nor any partner recognizes gain or loss. The new partner’s basis in the interest equals the money contributed plus the adjusted basis of any property contributed (§722), and the partnership takes contributed property with the partner’s adjusted basis (§723).

For example, if a new partner contributes property worth $500,000 with an adjusted basis of $200,000, the new partner’s basis in the partnership interest is $200,000, not $500,000, and the partnership’s basis in the property is also $200,000. The $300,000 of built-in gain is generally allocated back to the contributing partner under §704(c).

Revaluing Capital Accounts on Admission

If the partnership’s existing assets have appreciated, admitting a new partner without adjusting capital accounts can shift unrealized appreciation from the existing partners to the new one. The §704(b) regulations permit a partnership to revalue its property and restate capital accounts to fair market value in connection with a contribution of money or other property (other than a de minimis amount) by a new or existing partner as consideration for an interest in the partnership (Treas. Reg. §1.704-1(b)(2)(iv)(f)). A revaluation is permitted rather than required, so the partnership agreement should address it.

Liability Shifts When a Partner Joins

Partnership liabilities are allocated among the partners under §752. When a new partner is admitted, the existing partners’ shares of partnership liabilities may decrease. Under §752(b), a decrease in a partner’s share of partnership liabilities is treated as a distribution of money to that partner, which produces gain under §731(a)(1) to the extent it exceeds the partner’s basis in the partnership interest. Conversely, an increase in a partner’s share of liabilities is treated as a contribution of money (§752(a)). These shifts matter most in leveraged partnerships where a partner’s basis is low relative to that partner’s share of the debt.

When a Partner Leaves: Sale of the Interest

A departing partner may sell the interest to a new or existing partner. Under §741, the seller recognizes gain or loss, generally treated as capital gain or loss. Under §751(a), however, amounts attributable to the partnership’s unrealized receivables and inventory items are treated as received from the sale of property other than a capital asset, which generally produces ordinary income. The seller’s amount realized also includes relief from the seller’s share of partnership liabilities (§752(d)).

The partnership’s basis in its property generally does not change when an interest is sold unless a §754 election is in effect or the partnership has a substantial built-in loss immediately after the transfer (§743(a)). A substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds the property’s fair market value by more than $250,000, or if the buyer would be allocated a loss of more than $250,000 if the partnership sold all of its assets for fair market value immediately after the transfer (§743(d)). An adjustment under §743(b) applies only to the buying partner.

When a Partner Leaves: Liquidation by the Partnership

Alternatively, the partnership may liquidate the departing partner’s interest. The partner generally recognizes gain only to the extent money distributed, including any decrease in the partner’s share of liabilities treated as money under §752(b), exceeds the partner’s basis in the interest (§731(a)(1)). A loss is recognized only if the partner receives nothing other than money, unrealized receivables, and inventory, and then only to the extent the partner’s basis exceeds the money plus the basis of those items (§731(a)(2)).

If the partnership holds unrealized receivables or substantially appreciated inventory, §751(b) can treat part of a distribution that changes the partners’ shares of those assets as a taxable sale or exchange.

Payments to a Retiring Partner Under §736

Section 736 classifies payments made in liquidation of a retiring or deceased partner’s interest into two categories.

Section 736(b) payments are payments for the partner’s interest in partnership property. They are treated as distributions, so the general distribution rules above, including §751, apply.

Section 736(a) payments are all other liquidating payments. They are treated as a distributive share of partnership income if determined with regard to partnership income, or as a guaranteed payment if determined without regard to it. Either way, they are generally ordinary income to the recipient and reduce the remaining partners’ taxable income.

Payments for unrealized receivables, and payments for goodwill (unless the partnership agreement provides for a payment with respect to goodwill), are excluded from §736(b) and therefore fall under §736(a). That exclusion applies only if capital is not a material income-producing factor for the partnership and the retiring partner was a general partner (§736(b)(2) and (3)). It is chiefly relevant to service partnerships, such as professional practices. In other partnerships, payments for goodwill are generally treated as payments for the partner’s interest in partnership property under §736(b).

The §754 Election and Mandatory Adjustments

A §754 election allows the partnership to adjust the basis of its property under §743(b) when an interest is transferred and under §734(b) when property is distributed. The election is made in a written statement filed with the partnership return for the year of the transfer or distribution, by the return’s due date including extensions, and it applies to that year and all later years unless revoked (Treas. Reg. §1.754-1). Even without an election, adjustments are mandatory if there is a substantial built-in loss on a transfer (§743) or a substantial basis reduction of more than $250,000 on a distribution (§734(d)).

No More Technical Terminations

The Tax Cuts and Jobs Act repealed the “technical termination” rule, under which a sale of 50 percent or more of the interests in partnership capital and profits within 12 months terminated the partnership, for partnership taxable years beginning after December 31, 2017. A partnership now terminates only if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership (§708(b)(1)).

The Bottom Line

Admitting or removing a partner draws on several sets of rules: the contribution and basis rules of §§721 through 723, capital account revaluations, liability allocations under §752, sale treatment under §§741 and 751, liquidation treatment under §§731 and 736, and basis adjustments under §§734, 743, and 754. The partnership agreement, the balance sheet, and the partnership’s debt all affect the outcome.