Tax Aspects of Buy-SellsBy: Charles A. Wry, Jr.
April 11, 2011
This outline summarizes very generally certain of the federal income tax aspects of buying an owner out of a business operated in the form of an entity classified for tax purposes as a corporation, on the one hand, or a partnership, on the other.1
I. Redemption (Purchase by Entity)
1. Redeemed shareholder. The tax consequences of the redemption to the redeemed shareholder are generally determined under Internal Revenue Code (“Code”) Section 302. A complete termination of the shareholder’s interest in the corporation in a single transaction generally results in the shareholder being treated as having sold his or her shares, with the shareholder having gain or loss (capital if the shareholder held his or her shares as a capital asset, and long-term if the shareholder held the shares for more than a year) equal to any difference between the amount he or she realizes in the redemption and his or her share basis.2 Amounts paid to the shareholder can be treated as dividends, however, if (i) the redemption is effected serially rather than in a single transaction (so that the shareholder fails to satisfy the requirements for sale or exchange treatment under Section 302(b)) or (ii) remaining shareholders’ shares are attributed to the redeemed shareholder under applicable attribution rules (which can, at least in the family context, be waived under certain circumstances).
2. Corporation. Redemption payments (at least principal payments) are non-deductible (Code Section 162(k)). A redemption of a shareholder’s shares has no effect on the corporation’s basis in its assets.
3. Remaining shareholders. The remaining shareholders generally have no income unless they had the primary obligation to purchase the shares of the redeemed shareholder, in which case the corporation’s payments to the redeemed shareholder are deemed to be distributed to the remaining shareholders, who are then deemed to use the amounts to buy out the redeemed shareholder.3 The remaining shareholders can also be deemed to receive taxable stock distributions under Code Section 305 if the redemptions are part of a periodic redemption plan having the effect of the receipt of money or other property by the redeemed shareholders (in distributions to which Section 301 applies) and an increase in the interests of the remaining shareholders in the assets or earnings and profits of the corporation.
1. Redeemed partner. The tax consequences of the redemption to the redeemed partner are determined under Code Sections 736, 751(b) and 731 (and can be complicated). The amount paid to the redeemed partner is deemed to include any reduction in his or her share of the partnership’s debt.
A. Section 736. Section 736(b) provides that a payment by a partnership to a retiring partner in liquidation of the retiring partner’s interest in the partnership is treated as a distribution by the partnership to the partner to the extent the payment is made in exchange for the retiring partner’s interest in partnership property. Any portion of the payment that is so treated as a distribution is then directed on to Sections 751(b) and 731 (see below). Payments made by a partnership to a retiring partner that are not made in exchange for the retiring partner’s interest in partnership property are treated, under Section 736(a), as “distributive shares” of partnership income if determined with regard to the income of the partnership or as “guaranteed payments” if determined without regard to the income of the partnership. Any such distributive share allocations and guaranteed payments are generally reportable by the redeemed partner as ordinary income. If “capital is not a material income producing factor” for the partnership (i.e., the partnership is a service partnership) and the redeemed partner is a “general partner,” amounts treated as distributive shares or guaranteed payments under Section 736(a) include amounts paid to the redeemed partner for his or her interest in (i) any “unrealized receivables” of the partnership (which exclude, for purposes of Section 736, depreciation recapture and certain other items that are included in the definition for purposes of applying Sections 751(a) and 751(b)) and (ii) any goodwill of the partnership except to the extent that the partnership agreement provides for a payment with respect to goodwill.5
B. Section 751(b). To the extent that any amount paid to the redeemed partner and treated as a distribution (rather than a distributive share or guaranteed payment) by Section 736 is in exchange for the redeemed partner’s interest in “unrealized receivables” (including, among other things, depreciation recapture inherent in any depreciable property) or “substantially appreciated” (value in excess of 120% of adjusted basis) “inventory” (which includes, in addition to traditional inventory, property income from the sale of which would be ordinary) of the partnership, the redeemed partner is deemed to (i) receive the share of the unrealized receivables or inventory for which he or she is being paid cash in a non-liquidating distribution from the partnership (taking a basis in the distributed unrealized receivables or inventory equal to the lesser of the partnership’s basis in those assets or his or her basis in his or her interest in the partnership) and then (ii) sell the distributed unrealized receivables or inventory back to the partnership for the cash he or she is being paid for his or her interest in them. The deemed sale generates ordinary income for the redeemed partner to the extent of any excess of the cash payment he or she is deemed to receive for the unrealized receivables or inventory over the basis he or she took in those assets.
C. Section 731. Any amount that is paid to the redeemed partner, treated as a distribution (rather than a distributive share or guaranteed payment) by Section 736 and not treated under Section 751(b) as having been paid to the redeemed partner for the redeemed partner’s share of the partnership’s unrealized receivables or inventory produces gain (or loss) for the redeemed partner (capital if the redeemed partner held his or her interest in the partnership as a capital asset, and long-term if the redeemed partner held the interest for more than a year) to the extent such amount exceeds (or is less than) the redeemed partner’s basis in his or her interest in the partnership as of the time immediately before the distribution (minus the basis the redeemed partner took in any unrealized receivables or inventory deemed to have been distributed to him or her under Section 751(b)).
2. Partnership. Amounts treated as guaranteed payments to the redeemed partner under Section 736(a) are generally deductible expenses for the partnership. Amounts treated as distributive shares of partnership income to the redeemed partner under Section 736(a) generally have the effect to the remaining partners of deductible expenses because they would otherwise have to report the distributive share amounts. The partnership increases (or decreases) its basis in any unrealized receivables or inventory it is deemed to distribute to, and repurchase from, the redeemed partner to the amount of the deemed repurchase price. In addition, if the partnership has an election under Code Section 754 in effect, the partnership increases (or reduces) its asset basis by the amount of any gain (or loss) recognized by the redeemed partner under Section 731.6
3. Remaining partners. Because the profits and losses (and the component items of income, gain, loss and deduction) of a partnership are reported by its partners, the remaining partners get the benefit of their shares of the amounts paid to the redeemed partner that are deductible as guaranteed payments or treated as distributive shares of the partnership’s income. Any amounts by which the partnership can increase its bases in any of its assets will also inure, ultimately, to the benefit of the remaining partners. The remaining partners can have deemed distributions themselves, though, if their shares of any partnership debt are reduced or if they had the primary obligation to purchase the interest of the redeemed partner.
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1. Entities classified as partnerships for tax purposes include limited liability companies (“LLCs”), limited partnerships, limited liability partnerships and general partnerships (so long, in each case, as they have more than one owner and that have not elected to be classified as corporations).
2. It should be noted that losses on transactions between related parties can be disallowed. It is assumed in this outline that the disallowance rules are inapplicable.
3. Rev. Rul. 69-608, 1969-2 C.B. 42.
4. It is assumed in this Section I.b. and in Section II.b. that, after the redemption or purchase of the departing partner’s interest, the partnership has at least two remaining partners. See Section V. for a discussion of the applicability of the buy-sell rules to two-person partnerships.
5. Payments treated as distributive shares or guaranteed payments under Section 736(a) can also include amounts paid to the redeemed partner in lieu of interest and amounts paid to the redeemed partner in the nature of mutual insurance.
6. If 50% or more of the interests in a partnership’s capital and profits are sold within a period of twelve months, the partnership terminates for tax purposes under Code Section 708(b)(1)(B). For purposes of the termination rule, the liquidation of an interest in the partnership is not treated as a sale. See Regulations Section 1.708-1(b)(2).