New rules on payments to retired partners affect tax planning. (Federal Taxation)by Maydew, Gary L.
The Old Law
When an ongoing partnership makes payments in complete liquidation of a partner's interest, IRC Sec. 736 comes into play. It does not apply to partial liquidations, the sale of a partnership interest to another, or to liquidations of a partnership. The payments may be made due to the death of the partner, the reaching of retirement age, or simply a desire to terminate an interest in the partnership. In any case, payments are allocated between payments made for the interest in the partnership property IRC Sec. 736(b), and all other payments IRC Sec. 736(a). Payments under IRC Sec. 736(a) are considered to be either--1. a distributive share of partnership income if the amount of the payment is determined with regard to the income of the partnership; or
2. a guaranteed payment if the amount is determined without regard to the income of the partnership.
If considered a distributive share of income, the amount reduces taxable income for the remaining partners. If deemed a guaranteed payment, the payments are deducted by the partnership to arrive at ordinary partnership taxable income. In any case, IRC Sec, 736(a) payments reduce the taxable profits of the partnership. A guaranteed payment to a partner is always taxed as ordinary income; a distributive share of income is taxed subject to the conduit rules applicable to partnerships (i.e., the retiring partner would report his/her share of capital gains, charitable contributions, etc.).
Under the old law, payments for the partners' pro rata share of partnership assets were considered to be property payments IRC Sec. 736(b) payments, except for those payments for unrealized receivables or for goodwill that were in excess of the basis of the unrealized receivables or goodwill, which were considered IRC Sec. 736(a) payments. Note that payments for the basis of the unrealized receivables or goodwill have always been IRC Sec. 736(b) payments. However, to the extent that goodwill payments were provided for in partnership agreements, they were considered IRC Sec. 736(b) items IRC Sec. 736(b)(2) before amendment.
Payments under IRC Sec. 736(b) are considered to be a distribution by the partnership rather than a distributive share or a guaranteed payment. Therefore, they are taxed in the same manner as distributions in complete liquidation under IRC Sees. 731,732, and where applicable, 751 Reg. 1.7364(a)(2). Payments under IRC Sec. 736(b) cannot exceed the fair market value of the partner's share of the property. Generally, the valuation placed by the partners on the assets is regarded as correct if it is an arms-length agreement (i.e., the partners are not related and therefore have adverse interests) Reg. 1.736-1(b)(1). The gross value of the assets, not the net value of partnership liabilities, must be used. IRC Sec. 736(b) payments are entitled to capital gain treatment except for the portion that is for substantially appreciated inventory, which is taxed as ordinary income See. 751(a).
Example--Old Law. Madison, a 20% partner in the Jefferson, Madison, & Monroe partnership, a retailing business, retired from the partnership for a cash payment of $20,000. Goodwill was not provided for in the partnership agreement. An appraisal of the business resulted in the balance sheet as presented in the accompanying exhibit.
Assume all the appreciation in the equipment represents potential IRC Sec. 1245 gain. The total realized gain is computed as follows:
Under the old law, there would be IRC Sec. 736(a) payments of $3,200. This would consist of $1,400 of unrealized receivables (Madison's 20% share of the $7,000 appreciation in the equipment), and $1,800 (his 20% of the goodwill). The inventory would be substantially appreciated since the FMV exceeds 120% of basis and the FMV exceeds 10% of all of the assets except money. Hence, the breakdown of gain would have been as follows:
Under the old law, the partnership would have had a deduction for the $3,200 of IRC Sec. 736(a) payments, but would have no deduction for the IRC Sec. 736(b) payments. Thus, under the old law, the treatment of ordinary income payments under IRC Sec. 736(b) was not symmetrical.
The New Law
RRA '93 generally repeals the IRC Sec. 736(a) treatment for unrealized receivables and goodwill. However, an exception is made and these items remain IRC Sec. 736(a) payments if--
1. capital is not a material income-producing factor for the partnership; and
2. the retiring or deceased partner was a general partner in the partnership Act Sec. 13262, RRA '93.
Even service partnerships will no longer be able to deduct depreciation recapture as payments under IRC Sec. 736(a). Although depreciation recapture is considered an unrealized receivable for purposes of IRC Sec. 751, for purposes of IRC Sec. 736, unrealized receivables now include only income from the sale of ordinary income property (e.g., inventory) or from the provision of services which, under the accounting method of the business, have not been reported Act Sec. 13262(b)(1)(A), RRA '93.
The most common unrealized receivable is zero basis accounts receivable of a cash basis taxpayer. However, installment sales reported under the installment sales method also constitute an unrealized receivable, as do certain other transactions.
The House Committee report stated that the determination of whether capital is a material income-producing factor is to be made under principles of present and prior law. e.g., IRC Secs. 401(c)(2) and 911(d) and old IRC Sec. 1348(b)(1)(A). The Committee noted that capital is not a material income-producing factor if substantially all of the gross income of the business consists of fees, commissions, or other compensation for personal services performed by an individual. Therefore, practices of doctors, dentists, lawyers, architects, or accountants will not be treated as a material income-producing business even if there is a substantial capital investment. so long as the capital is merely incidental to the professional practice. The Committee also noted that the bill does not affect the deductibility of compensation paid to a retiring partner for past services.
Although the committee reports on Act Sec. 13261 give no rationale for the change, apparently Congress removed the deduction for payments for goodwill and unrealized receivables in conjunction with the new amortization rules for intangibles. According to a staff member of the Joint Committee on Taxation, Congress wanted to ensure that partnerships did not have a back-door way of deducting goodwill (as a Sec. 746(a) payment) when other entities must amortize goodwill. The connection of unrealized receivables to the new rules on intangibles is much more tenuous, but Congress apparently felt that allowing partnerships to deduct payments to partners attributable to unrealized receivables gave them an advantage that other entities lacked.
These provisions generally apply to partners retiring or dying on or after January 5, 1993. However, the new rules do not apply to partners retiring on or after January 5 if at that date there was a binding written contract to buy the partner's interest.
A related change was made to the rules for determining "substantially appreciated inventory." Under prior law, the inventory must have been worth more than 120% of the basis and the inventory value must also have exceeded 10% of the fair market value of all partnership property, other than money. RRA '93 removes the 10% requirement Act. Sec. 13206(e), RRA '93. The Act also provides that property acquired with the principal purpose of reducing the appreciation below 120% is to be disregarded in computing the 120%.
Impact of the Law Changes
The impact of the change in IRC Sec. 736(a) payments is generally disadvantageous to the partnership and in the case of unrealized receivables, neither helps nor hinders the partner. The disadvantage of IRC Sec. 736(a) payments is that they are taxed to the retiring partner as ordinary income; the advantage is that they are deductible to the partnership. Taking unrealized receivables and goodwill from IRC Sec. 736(a) removes the deduction to the partnership; however, payments likely will remain ordinary income to the partners because unrealized receivables constitute a part of substantially appreciated inventory (the share of which is taxed as ordinary income to the partner).
Example--New Law. Assume the same facts as in the previous example. Recall that under the old law, the partnership would have had a deduction for the $3,200 of IRC Sec. 736(a) payments, but would have no deduction for the IRC Sec. 736(b) payments.
Under the new law, payments for the unrealized receivables and goodwill would not be IRC Sec. 736(a) payments. Thus, the results would be as follows:
Because the entire $10,000 is now a 736(b) payment, the partnership would lose $3,200 of deductions.
The removal of the 10% rule for substantially appreciated inventory (discussed above) makes it more likely that liquidating distributions to retiring partners will be the worst of both worlds, i.e., resulting in ordinary income to the retiring partner, but giving no deduction to the partnership. This change will make it even more likely that inventory, unrealized receivables, and depreciation recapture will meet the test of "substantially appreciated."
Tax Planning Implications
Given the law change, what sort of payments will meet the IRC Sec. 736(a) criteria so as to achieve deductibility to the partnership? The key is to structure partnership agreements so as to pay retiring or deceased partners for their income interests. The House Committee noted that the bill does not affect the deductibility of compensation paid to a retiring partner for past services. Thus, partnership agreements could contain provisions to compensate retiring or deceased partners either in the form of guaranteed payments or distributive shares of income. Is it better to have IRC Sec. 736(a) or IRC Sec. 736(b) payments? The answer depends on the differential, if any, between capital gains rates and ordinary income rates to the retiring partner. The partnership will always prefer IRC Sec. 736(a) payments. However, a retiring partner who expects to be subject to a marginal rate of say 39.6% would distinctly prefer IRC Sec. 736(b) payments since those payments (except for substantially appreciated inventory) would be subject to a ceiling capital gains rate of 28%. A retiring partner in a more modest income situation (e.g., married filing jointly with taxable income not expected to exceed $91,850 in 1994) would be indifferent between IRC Sec. 736(a) and IRC Sec. 736(b) payments.
It should also be noted (as discussed above) that most service concerns will still be able to characterize unrealized receivables and goodwill as IRC Sec. 736(a) payments. As a result, service partnerships will have more flexibility than other partnerships.
The preceding discussion covered only some aspects of IRC Sec. 736(a) versus IRC Sec. 736(b) payments. Consideration of differences in the timing of recognition of IRC Sec. 736(a) and IRC Sec. 736(b) payments, allocations of payments between IRC Sec. 736(a) and IRC Sec. 736(b), and basis elections under IRC Sec. 754 are essential to effective tax planning. The impact of IRC Sec. 736(a) payments on self-employment tax and passive activities is also important. The new law will make even more critical a well-developed partnership agreement to cover the retirement and death of partners.
Gary L. Maydew, PhD, CPA, is associate professor at Iowa State University. He is a frequent contributor to professional journals including The CPA Journal.
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