Key differences between redemption and sale of partnership interests
Updated 01/25/18 to reflect new technical termination rules under tax reform.
There are substantial tax differences between a redemption (a partner is redeemed out by the partnership) and a sale of a partnership interest. These include:
Character of gain due to the “look-through” rules
With a redemption, all income could be capital gain except for Section 751 hot assets (including substantially appreciated inventory). With a sale, the look through rules include Section 1245 and 1250 recapture and collectible gains special tax rates while any inventory and Section 751 hot asset sales are ordinary income.
On a redemption, generally the step-up in basis applies to all remaining partners, while with a sale, generally a step-up only applies to the purchasing partner. Also, if the partnership interest is being redeemed or sold over a few tax years, a sale generally allows the purchasing partner to get the step-up in its share of the partnership’s assets immediately, while with a redemption the step-up is not recognized until the exiting partner's basis is recovered. Then in a redemption, the remaining partner(s) receive the step-up(s) as the exiting partner recognizes gain.
A redemption allows a 50 percent or more partner to exit without causing a technical termination. A sale of 50 percent or more would cause a technical termination. There are various tax consequences of a technical termination including that the depreciable life of all property, plant and equipment at their net basis starts anew. For example, a commercial building purchased in 1989 with a net basis (after depreciation) of $400,000 would then be depreciated over a new life using $400,000 as the depreciable basis.
For partnership tax years beginning after Dec. 31, 2017, the Tax Cuts and Jobs Act repealed technical terminations when 50 percent or more is sold or exchanged unless the business is no longer carried on. The technical termination provision was one reason for real estate entities to use a redemption versus a sale, due to the fact that depreciation lives had to begin anew.
Timing of gain by exiting partner
When payments are to be paid over two tax years, a partner whose interest is redeemed can generally use the basis recovery rule, while a sale generally can be reported as an installment sale. If a partnership has no substantially appreciated inventory, a redemption allows a partner to defer the gain until the basis of the partnership interest is recovered, but a sale can be treated as an installment sale, with all ordinary income recognized in the first year and the partner's basis generally being allocated over the installment period.
If a redemption of a partner's interest is the desired treatment, it is very important to structure the redemption properly so that it will withstand IRS scrutiny and not be re-characterized as a disguised sale. The disguised sale regulations must be reviewed carefully in all redemptions. One example of a disguised sale can be when a new partner contributes capital and then the old partner is bought out with the new capital. Thus, it is important that the redemption payments come from partnership assets or partnership loans, rather than an infusion of cash from a new partner.