Option 2 since it might be the most reasonable. Just because Carol is ready to retire does not mean
that Amy and Bob are ready to close the partnership. Also, it can be hard to find an outside buyer
unless they have someone in mind.
Option 2 states that the partnership should borrow money to pay for Carol’s interest in the business.
The sale or exchange of a partner’s interest in a partnership usually results in a capital gain or loss
(IRS 2022). Depending on what Carol has contributed to the partnership and what her adjusted basis
is in the partnership at the point of sale will determine whether she will recognize a gain or loss. In
order to prevent retiring partners, the opportunity to convert ordinary income to capital gain,
however, IRC section 751 requires the selling partner to recognize ordinary income to the extent of
any gain attributable to IRC section 751 property (Smith 2021). 751 property is unrealized
receivables and inventory type items.
As for the partnership IRC section 736 determines which type of payments are treated as
distributions or income. IRC section 736 divides payments into two categories: section 736(b)
payments, which are taxed under the normal partnership distribution rules, and section 736(a)
payments, which are treated either as part of the retiring partner’s distributive share of partnership
income if determined with respect to the income of the partnership, or as a guaranteed payment if
determined without respect to the income of the partnership (Smith 2021). The payments to Carol
are typically classified as distributions.
If Carol passes before any plan is put into place, then her estate/successor would become a partner.
For income 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 2022).
Since Carol has decided to retire, I think the best course of action is to find a suitable outside buyer
for her interest in the business. In my opinion, finding an outside buyer it is more practical to do so,
instead of selling the entire business because one of the shareholders is retiring or having the other
two partners borrow money to buy out Carol. When Carol decides to sell her share, she will treat
the gain or loss on the sale as the sale of a capital asset, according to IRC 741 (Cornell, 2022). In this
case, the other partners are not affected as Carol’s share of the partnership will be treated as a
separate entity.
If by chance Carol happens to pass away before the sale of her partnership share is complete, the
benefactor of her stake in the business now becomes the partner. There are a few options to
consider in this case: liquidating the business and distribute the remaining assets, have Carol’s heirs
become partners, or buy out Carol’s heir’s share of the business. In a properly arranged partnership,
there usually is some jargon that will explain what will happen if a partner passes away, typically
ending up with the partners buying out the deceased owner’s share of the business (New York Life,
2022).
To base my observation on option one which was to sell the business and distribute part of the
proceeds to each partner because, in my opinion, it is the most straightforward option for the
partners. When the partners sell the business, assuming they are all equal partners, then we can
insinuate each partner will receive an equal amount from the sale. Then the gain or loss from the
sale will pass through to the partner's personal tax returns. Therefore, each partner could claim the
amount of their basis tax-free on their income taxes. If the distribution is more than their basis, then
they will be required to have to report a gain on their tax returns. Gains are generally taxed as long-
term capital gains, therefore if the partners have held an interest in the partnership for more than a
year then they will pay lower tax rates on the gain than they would on a partnership’s operating
profit. Also, if the distribution is less than their basis, then it would be best if they will report a loss.
If the partnership distributes property to the partners, there is no tax effect until the property is
sold. However, before any of the partners receive a distribution, all debts will need to be paid off,
which means the remaining amount would be distributed to the partners.
Now if we were to look at Carol, if Carol were to die before they sell the partnership, the partnership
would dissolve, then the assets are sold to pay debts, and then the remaining amount is distributed
to the other partners. Another option would be to look for a clause in the partnership agreement
that specifies what shall happen to the partnership in the case of a death. This would be ideal since
it specifically says what is to happen to the partnership, which simplifies things and allows the
partnership to potentially avoid probate court.
When one partner wants to leave the business, the simplest solution is to ask them to find an
outside buyer for their stake and keep the sale isolated to that. This solution is easier than the other
two, because buyers need less money than they would to buy the whole thing, and the other
partners do not need to borrow anything.
The IRS (n.d.) explains that when the sale of a partnership interest occurs, it is done by the entity
theory, not the aggregate theory. That means the interest that the partner holds, not a portion of
the underlying assets within the business. So, essentially whatever Carol sells her piece for above
the value of her total basis represents her gain. Furthermore, Anderson et al. (2023) explains that
the gain or loss created from this sale represents a capital gain or loss under Sec. 741. However,
when the asset is IRC 751, they must recognize ordinary income or a loss. The same thing goes for a
Sec. 1250 asset, which is subject to an unrecaptured gain. As far as the rest of the partnership goes,
when a buying partner acquires a stake at, the other partners can elect to make a special IRC 743(b)
basis adjustment and use the new given value as their FMV. c
If Carol were to pass away before the plan is executed, it makes things a bit more complicated. New
York Life (n.d.) explains that the first important thing is that the partners have a plan for if this were
to happen. Generally, the heirs to Carol's estate will take hold of the business. The entire business
could be liquidated, the heirs can become new associates, their stake can be sold, or the other
partners could buy it out. We know that since Carol was going to sell the business, her heirs likely
would as well. They simply will inherit the shares at Carol’s basis and sell them the same way she
would have.
IRS. (n.d.). Sale of a Partnership Interest. Retrieved from: https://www.irs.gov/pub/irs-
utl/sale_of_partnership_interest.pdf
Anderson, K., Hulse, D., and Rupert, T., Prentice Hall’s Federal Taxation 2023 Corporations,
Partnerships, Estates & Trusts. 2023.
New York Life. (n.d.). What to do if your business partner dies. Retrieved from:
https://www.newyorklife.com/articles/your-business-partner-died-tonight
Anderson, K., Hulse, D., Rupert, T. (2023). Prentice Hall Federal Taxation 2023: Corporations,
Partnerships, Estates, and Trusts.
Legal Information Institute. (n.d.). 26 U.S. Code § 741 - recognition and character of gain or loss on
sale or exchange. Legal Information Institute. Retrieved March 23, 2023, from
https://www.law.cornell.edu/uscode/text/26/741
New York Life. (2022, December 6). What happens if my business partner dies? What Happens if My
Business Partner Dies? | New York Life. Retrieved March 23, 2023, from
https://www.newyorklife.com/articles/your-business-partner-died-
tonight#:~:text=Business%20partnership%20agreement,from%20his%20or%20her%20heirs.
Internal Revenue Service (IRS). (March 30, 2022). Publication 541, Partnerships.
https://www.irs.gov/publications/p541#en_US_202203_publink1000104336
Smith, Eric. (February 2021). Tax Treatment of Liquidations of Partnership Interest. CPA Journal.
https://www.cpajournal.com/2021/02/09/tax-treatment-of-liquidations-of-partnership-interests/
