Category: Partnerships &
LLCs Copyright 1998, The Tax Resource Group. All
rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer is an LLC providing services. Taxpayer has three equal membersA, B, and C. C is retiring from the business. The parties have arrived at a buyout price for C's interest. If the LLC buys out C, then the question is whether the deal can be arranged so the LLC can deduct some of the buyout price. The LLC in this case is treated as a partnership for federal tax purposes. Payments from a partnership to a retiring partner are controlled by Section 736. Such payments must fall into one of two broad categories: A) payments attributable to the partner's share of partnership property--Section 736(b) payments; or B) payments of partnership income--Section 736(a) payments. Payments for partnership property, Section 736(b) payments, are not deductible by the payor partnership. Payments for partnership income, Section 736(a) payments, are treated either as the retiring partner's distributive share--Section 736(a)(1)or as guaranteed payments--Section 736(a)(2). Obviously, Section 736(a)(1) payments simply reduce the total amount of partnership income that would otherwise have been allocated to the remaining partners while Section 736(a)(2) payments are treated as an actual partnership-level deduction. The default classification of a payment to a retiring partner is Section 736(b), payment for partnership property. To the extent a payment is not so considered, the payment is then deemed to be a payment of partnership income under Section 736(a). An arms's-length agreement among the parties as to classification is generally respected. The starting point is the partnership balance sheet and the valuation placed on each partnership asset (including goodwill). To the extent payments to a retiring partner are attributable to the partner's share of the gross value of partnership assets, such payment are considered Section 736(b) payments. For a service partnership there is another consideration. Section 736(b)(2) provides that payments attributable to partnership unrealized receivables and goodwill--unless the partnership agreement explicitly provides for payments against partnership goodwill--are to be treated as payments for partnership income, i.e., Section 736(a) payments. But, the mandatory treatment of such payments from a service partnership applies only if... A) capital is not a material income producing factor (i.e., substantially all the income is produced by services, even if there is a substantial capital investment in the business for equipment, etc.); and B) the retiring partner is a general partner. This rule, set forth at Section 736(b)(3), does not appear to apply in this case. The rule turns on the retiring partners being a general partner. Here, the taxpayer is an LLC, and presumably an LLC member is not a general partner. I personally expect this rule to change, and I personally expect the Service to attempt to somehow "end-run" the statute with an announcement or something. To date, however, they have not done so. I suspect the parties have determined the buyout price for C in terms of the value of partnership assets. As such, I suspect there is little or nothing that could be treated as a Section 736(a) payment in this case. |
