As Carol plans to retire from The Marina, marina owners Bob, Amy, and Carol have started to discuss
what will happen to Carols share of interest since she no longer wants to be actively involved in the
operations or decision-making process of running The Marina. As they all have interest in The
Marina, they all must decide together what to do with Carols share of interest. They have ruled out
selling the business as Bob and Amy wish to continue operations and Carol is okay with the
continued operation of The Marina after she retires. Taking on additional debt to buy Carol out also
is a not an option because Bob and Amy have no desire to take on additional debt to buy Carol out.
Bob and Amy have approached Carol with another alternative if she does not want to liquidate her
share of interest entirely, she can find a buyer for her share of interest in the business. Carol is
considering this as the better alternative since it will allow The Marina to continue without an
interruption into normal business operations. Bob has done some research and found that the IRS
has laid out some specific guidelines around the sale of interest and the related transaction. Under
IRS guidelines the ownership interest in The Marina is treated as an asset that can be purchased or
sold. Carol will treat the proceeds from the sale of her interest as the sale of an asset and will pay a
tax on the gain or loss on sale of her ownership interest; and ownership interest must be sold are
fair market value.
Bob and Amy will not be involved in the sale and Carol can sell her ownership interest to another
person, legal entity, partnership, or corporation as she pleases and after the sale, she will notify Bob
and Amy that the sale has been completed. The sale will be reported on the Form 1065 tax return
and Carol will be issued a final K-1. Carols ownership interest accounts will be reduced to $0 and the
new partners ownership interest will be increased to similar amounts. When the IRS reviews returns
for completeness and accuracy, they look at these details to indicate if there was a sale of ownership
interest. Carol will also report the sale on her Form 1040 as Schedule D, Capital Loss or Gain and will
include Form 8949 and Form 4797 as needed. In Carols best interest she should ensure that the sale
of the transaction is reported according to IRS code, any deviation from the code could see as
fraudulent intent or a motive to avoid paying taxes.
It is agreed upon that if Carol chooses to sell her ownership interest she would find a suitable buyer,
but in the event of her untimely death, Bob and Amy will have quite a tedious task on their hand to
reorganize the partnership if there is no formal agreement in place at the time of her death. If
business operations ceased altogether after Carol dies the partnership will have to be dissolved. Any
income made by Carol will be reported on her final return and her estate will have to decide rather
they would like to obtain ownership of her share in ownership interest. If Carols estate does not
want to obtain her ownership interest Bob and Amy may have to buy out her ownership interest or
they could try to find a suitable buyer for her share of ownership interest. In the worst-case scenario
if Amy and Carol cannot find a suitable buyer or the estate does not obtain ownership interest, they
will have to sell the business completely or close if services offered by Carol cause business activities
to stop.
Bob, Amy, and Carol should review their partnership agreement to ensure that events such as
untimely deaths are addressed.
Option 2: Borrow money to pay for Carol’s interest in the business.
If Carol chooses to take a liquidating distribution of less than her basis in the partnership, she will
recognize a loss for tax purposes. c If she takes anything other than money, unrealized receivables,
and inventory she will recognize no loss. c She will recognize a gain only if she receives more money
than what her redistribution basis is in her portion of the partnership. c Section 751 requires partners
to recognize ordinary income or loss on the sale or exchange of a partnership interest if it is
attributable to the partner’s share of unrealized receivables and inventory.
The general rule for partnerships is that no gain or loss is recognized by the partnership in a
liquidating distribution to one partner, unless it is a section 751 sale or exchange.
If Carol dies before the liquidating distributions are made, her successor-in-interest would take
payments from the partnership for Carol’s interest in the partnership. c Payments made for property
will not be deductible for the partnership and may not be income for the successor-in-interest. c If
payments exceed the value of that partner’s share of partnership property and are treated as a
guaranteed payment, Carol, or her successor-in-interest, recognizes ordinary income, and the
partnership generally has an ordinary deduction.
If the partners choose to liquidate the partnership, they are distributing the partnership assets to
the partners. The partner will recognize a gain if deemed money is distributed that exceeds their pre
distribution basis. Deemed money includes cash, a reduction in liabilities, or FMV securities. In a
liquidating distribution a partner can recognize a gain or loss unlike a current distribution which can
recognize a gain only. If the liquidating distribution has deemed money, unrealized receivables, or
inventory and no other property while the partner’s basis in the partnership interest is more than
the total basis the partnership has of the distributed property, a loss can be recognized. If there is
other property distributed the partner cannot recognize a loss and the partner’s basis is allocated
the property. After a liquidating distribution a partner has zero basis in the partnership. If there are
Sec 751 assets the partner must determine the gain or loss on those assets and record it as ordinary
income.
If Carol was to perish before any of the transactions occurred, her ownership would be part of her
estate. All the partners should develop a plan to determine what happens when one of them dies,
do they want a designated heir to take part in the partnership, do the other partners buy the estate
out of the partnership, or do they liquidate the partnership. With planning they can think ahead
which will make their passing easier for their loved ones and their business partners.
c When a partner retires or dies and is in a partnership, the remaining partners have a few options to
discuss. They can sell the business outright and circulate the profits amongst the partners. They can
take on debt and buy the partner’s interest in the business. Lastly, the partner leaving could sell
their stake in the business to a new buyer. In the case of ABC Marina, Amy and Bob have just been
informed of Carols intention to retire.
After much deliberation, Amy and Bob decided to ask Carol to find a new buyer to take over Carol’s
interest in the business. The new partner does not need to have a name that starts with “C”, but it
sure would be nice. When Carol sells their interest in ABC Marina, this will have no tax
consequences on the partners. Carol, however, will need to recognize capital gains or loss because
partnership interest is generally a capital asset. “Section 751 requires the partner to recognize
ordinary income or loss to the extent of the partner’s share of unrealized receivables and inventory
items” (Anderson 2023). Partnership liabilities are part of each partners’ basis in the partnership.
When Carol sells their interest in ABC, Carol will be relived of partnership liabilities. They will
become part of the new partner’s basis in the firm.
If Carol were to die before the sale is executed, payments made to their estate for unrealized
receivables and goodwill are not considered payment for property. These payments are considered
as other payments. These payments can be deducted or used to reduce the distributive share
allocable to the other partners. Hopefully, Carol has a robust estate plan and funds can flow easily to
the designated person/people/trust(s).
Reference:
Anderson, Kenneth, et al., editors. Pearson’s Federal Taxation 2023 Corporations, Partnerships,
Estates & Trusts. Pearson Education, Inc, 2023.
Anderson, K. E., Rupert, T. J., & Hulse, D. S. (Eds.). (2023). Pearson’s Federal Taxation 2023
Corporations, Partnerships, Estates & Trusts. Pearson
Anderson, Kenneth, et al., editors. Pearson’s Federal Taxation 2023 Corporations, Partnerships,
Estates & Trusts. Pearson Education, Inc, 2023.
Ellen tuck, A. (2015, August 1). Accounting for the Death of a Partner. Retrieved March 24, 2023,
from https://www.thetaxadviser.com/issues/2015/aug/accounting-for-death-of-partner.html.
LB & I Transaction Unit, IRS.gov (2021). Retrieved March 23, 2023, from
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