Option 1: Sell the business and distribute part of the proceeds to each partner
Considering Bob, Ann, and Carol's business is a partnership, if they were to sell the business and
distribute some of the proceeds to partners, there would be a few tax consequences for both the
partnership and the partners. There are two options when selling a business, you can either sell
the stock option or sell the company's assets (U.S. Bank, n.d.). With a partnership being a pass-
through entity, the best option for pass-through entities would be to sell the company's assets.
This option would steer the seller away from additional taxes that they would face if they
characterized a sale of stock. With the sale of the company's assets, the proceeds would be
distributed to each partner and would most likely be recognized as a long-term capital gain. Long-
term capital gains are subject to 20% federal capital gains tax, and depending on the state, it could
be subject to additional state taxes. Buyers would typically prefer purchasing a company's assets
as well, because most tax laws allow for the buyer to deduct the purchase price of the asset. If
Carol were to die before the sale of the business, her portion of the estate would be subject to
large estate taxes (U.S. Bank, n.d.). This is why it is recommended to set up a thorough and up-to-
date estate plan. This way they could set up annual gifts to family or organizations that meet the
annual gift tax limit, therefore they wouldn't be subject to gift tax and this would reduce the value
of the estate, reducing estate taxes. In partnership business context, liquidation refers to the
process in which the business is wound up and the assets are distributed among the partners. In
the context of the partnership marine business that was established several years ago by Amy,
Bob and Carol, one of the partners (Carol) has decided to retire. An available option that can be
considered is to sell the business that belongs to Carol so that the processed can be distributed
among the remaining partners. In case such a decision is made, it is essential to take into account
the tax consequences. In case the partnership is a pass-through entity, it will not have to pay any
corporate tax. According to the Internal Revenue Service (IRS), in the case of partnership
business, instead of paying tax, it has to the ‘pass through’ the losses or profits to the partners
(Partnerships: Internal Revenue Service). In case the marine business is a pass-through entity, it
will not give rise to any tax implications at the business level, instead, the profits or losses of the
partners will be passed on to them on which individual tax returns will be applicable. It is
necessary to carefully understand how tax can be treated so that the assets of the partner can be
carefully transferred (Jestl, 2021). In case the partnership business is structured as a corporation,
then the possibility of double taxation may arise. This is because the tax will have to be paid at
the corporate level as well as at the individual partner level. As in the specific context, out of the
three partners, only Carol has decided to retire, the sale of the business and the subsequent
distribution of her part of the proceeds to each partner will give rise to taxation implications only
at the partner level as they will be taxed just like they are taxed on their personal income.If Carol
dies before the plan relating to the sale of her portion of the business is executed, the tax
implications are likely to vary. Generally, when a partner dies, his portion of assets as well as
liabilities, get passed on to their respective heir. In terms of taxation, it is instrumental to make
appropriate adjustments in order to make sure that the assets of the deceased partner reflect the
fair market value of Caro’s share during the time of her death. It is instrumental to do such an
adjustment since it can help to decrease the taxable increase in the deductible loss when the assets
are sold in the future. In case the partnership agreement includes an option relating to a buyout of
Carol’s share, the amount of money relating to the buyout would be subject to estate tax. The
other surviving partners i.e., Amy and Bob would have to report such as amount as taxable
amount so that appropriate tax computations can be made. It has been identified that in the case of
partnership liquidation, it has to make liquidating distributions as per the positive capital account
balance of a partner (Lessambo, 2021).
There are tax consequences to each one of the retirement options. If Carol was to sell the
business and distribute part of the proceeds to each partner, this would have the biggest effect on
partners. Each one of the partners would have to recognize the gain or loss and return it on their
personal tax returns as income/loss or capital gains/losses. Which type would be dependent on
the amount each partner receives as well as the type of distribution. ‘A partner recognizes gain
only if any money distributed exceeds the partner’s pre distribution basis in his or her partnership
interest’ (Rupert, 2019). ‘A partner’s sale or exchange of a partnership interest would generate a
capital gain or loss under SEC. 741 because a partnership interest is usually a capital asset’
(Rupert, 2019). d It is important to establish a formal plan because if Carol were to pass away prior
to the sale. If there were a plan in place, no changes would be made other than the proceeds
going to the estate rather than Carol.
Before considering liquidating the partnership, Carol must first understand the certain procedures
and guidelines in doing so within the state her and her partners business is in. "Liquidation is the
process of settling all business liabilities and valuing and disposing of a business's assets. When
your company is organized as a partnership, liquidation involves state law and the way your
business affairs are structured" (Masters 2016 p 1). Since Carol is the only partner that plans on
retiring, she should first, review the partnership agreement they all prepared when they began the
business. That would be the first step on determining what needs to be done in order to continue
the positive relationships between all partners. In this case only one of the partners is ready for
retirement, therefore selling the business as a whole would be unfair for the other two partners,
should they consider continuing with the business based on the partnership agreement they
formed at the beginning.
The best option in this case would be option 2: borrow money to pay for Carol's interest in the
business.
"Payments made in liquidation of the interest of a retiring or deceased partner in exchange for
their interest in partnership property are considered a distribution, not a distributive share or
guaranteed payment that could give rise to a deduction (or its equivalent) for the partnership"
(IRS). This option is more so the better option because they would not have to collectively agree
to retire or sell the business, the other two partners can continue it on nor would they have to, if
they did not want to, bring in another buyer to take over Carol's interest. Option 3 would be a
good idea if the outside buyer was a family member of Carol's or one of the other owners as they
would already have some sort of relationship with the business. "Upon the receipt of the
distribution, the retiring partner or successor in interest of a deceased partner will recognize gain
only to the extent that any money (and marketable securities treated as money) distributed is more
than the partner's adjusted basis in the partnership. The partner will recognize a loss only if the
distribution is in money, unrealized receivables, and inventory items. No loss is recognized if any
other property is received" (IRS).
Should Carol pass away before this option is decided then the successor would become the
partner in her place. According to the IRS and for tax purposes, "a retiring partner or successor in
interest of a deceased partner is treated as a partner until their interest in the partnership has been
completely liquidated" (IRS). It is and would be a good idea for all partners in any partnership
review and keep the partnership agreement updated and as accurate as possible should anything,
such as a death occur.
References:
Masters, T. (2016, October 26). How to liquidate a General Partnership. Small Business -
Chron.com. Retrieved March 26, 2023, from https://smallbusiness.chron.com/liquidate-general-
partnership-52532.html
Publication 541 (03/2022), Partnerships. Internal Revenue Service. (n.d.). Retrieved March 26,
2023, from https://www.irs.gov/publications/p541#en_US_202203_publink1000104336
Rupert, T. J., & Anderson, K. E. (2023). Prentice Hall’s Federal Taxation 2022.
Jestl, S. (2021). Inheritance tax regimes: a comparison. Public Sector Economics, 45(3), 363-385.
Lessambo, F. (2021). US Taxation of Partnerships: Advanced Topics. Kluwer Law International
BV.
Partnerships: Internal Revenue Service (no date) Partnerships | Internal Revenue Service.
Available at: https://www.irs.gov/businesses/partnerships (Accessed: March 23, 2023).
