The IRS Classify Buyout Payments If you make installment payments to buy out a partner, those payments are classified in one of two ways: Section 736(a) payments are guaranteed payments to an existing partner. They are tax deductible for the business and taxed as ordinary income for the recipient.
Please take into account some of potential issues such as:
Did an ownership change occur where one partner sold an interest in the partnership to a new or existing partner?
Did the partner who sold an interest in the partnership properly report the gain or loss?
Did the selling partner consider whether the partnership has any IRC 751 assets and treat any of the gain or loss on the
sale of the partnership interest as ordinary income?
Did the selling partner consider whether the partnership has any IRC 1250 assets and treat any of the gain or loss on the sale of the partnership interest as being subject to tax at the unrecaptured IRC 1250 gain tax rate?
Did the partnership have an IRC 754 election in place? If so, did the partnership correctly compute the IRC 743(b)
Keep in mind, When a sale of a partnership interest occurs, the entity theory is the underlying concept, not the aggregate theory. This means the ownership interest a partner has in a partnership is treated as a separate asset that can be purchased and sold.
The general rule is the selling partner treats the gain or loss on the sale of the partnership interest as the sale of a capital asset (see IRC 741).
An exception to the general rule exists when the partnership entity holds certain types of assets. The aggregate rule comes into play and the look-through concept is applied where the partner may have to characterize part of the gain or loss on the sale of the interest as subject to different tax rates based on the types of assets owned by the partnership entity.
When the partnership owns IRC 751 assets, the selling partner must recognize ordinary gain or loss respecting the partner’s share of those assets.
The same type of exception applies for assets subject to unrecaptured Section 1250 gain treatment. Like for IRC 751 assets, the selling partners must allocate the gain or loss based on the partner’s share of the IRC 1250 assets as subject to unrecaptured Section 1250 gain. Section 1250 gain has a higher tax rate than the capital gain tax rate.
Because fair market value (FMV) tends to change over time, when the buying partner acquires the partnership interest at FMV, its outside basis in the partnership interest likely differs from its share of the partnership’s inside basis in its assets. If the partnership elects under IRC 754 to make a special IRC 743(b) basis adjustment, the difference goes away.
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