Business Entities · Partnerships

Dissolution of partnership (e.g., sale, death of partner)

The tax law’s idea of a partnership ending is narrower than the commercial one. A firm can change every partner it has, sell most of its interests, admit new investors and reconstitute itself under a new name without terminating for tax purposes. What ends a partnership is the business stopping — and since 2018 that is the only thing that ends it, a recent change much material has not absorbed.

The rule

Continuation, and the only termination. an existing partnership is considered as continuing if it is not terminated, and is terminated only if no part of any business, financial operation or venture of the partnership continues to be carried on by any of its partners in a partnership (IRC § 708(a), (b)(1))^TY2026

What used to be the second one. the former IRC § 708(b)(1)(B) terminated a partnership where within a 12-month period there was a sale or exchange of 50 percent or more of the total interest in partnership capital and profits. Pub. L. 115-97 struck that subparagraph for partnership taxable years beginning after 31 December 2017, so the technical termination no longer exists^TY2026

Mergers and divisions. on a merger or consolidation the resulting partnership is the continuation of any merging partnership whose members own more than 50 percent of the capital and profits of the resulting partnership; on a division, a resulting partnership is a continuation of the prior partnership where its members had an interest of more than 50 percent in the capital and profits of the prior one (IRC § 708(b)(2))^TY2026

When the year closes. the taxable year of a partnership does not close on the death of a partner, the entry of a new partner, the liquidation of a partner interest or the sale or exchange of an interest — except that it closes with respect to a partner whose entire interest terminates, whether by death, liquidation or otherwise, and does not close with respect to a partner who disposes of less than their entire interest (IRC § 706(c)(1), (2))^TY2026

Liquidation payments, first category. payments in liquidation of the interest of a retiring or deceased partner are, except as IRC § 736(b) provides, a distributive share of partnership income if determined with regard to partnership income, and a IRC § 707(c) guaranteed payment if determined without regard to it (IRC § 736(a))^TY2026

Second category. to the extent such payments are determined to be made in exchange for the partner interest in partnership property, they are treated as a distribution by the partnership rather than as a distributive share or guaranteed payment. Payments for unrealised receivables, and for goodwill except where the partnership agreement provides for a goodwill payment, are excluded from that treatment — but only where capital is not a material income-producing factor and the retiring or deceased partner was a general partner (IRC § 736(b))^TY2026

Recognition on a distribution. gain is not recognised to a partner on a distribution except to the extent money distributed exceeds the adjusted basis of the partner interest immediately before it; loss is not recognised except on a liquidating distribution consisting only of money, unrealised receivables and inventory, and then only to the extent the basis of the interest exceeds the money plus the basis of those items. No gain or loss is recognised to the partnership (IRC § 731(a), (b))^TY2026

Basis of property distributed currently. the basis of property other than money distributed other than in liquidation of a partner interest is its adjusted basis to the partnership immediately before the distribution, but may not exceed the adjusted basis of the partner interest reduced by any money distributed in the same transaction (IRC § 732(a))^TY2026

And in liquidation. the basis of property other than money distributed in liquidation of a partner interest is the adjusted basis of that interest reduced by any money distributed in the same transaction — so the partner outside basis is transferred into the property received (IRC § 732(b))^TY2026

How that basis is spread. where basis must be allocated among distributed properties it goes first to unrealised receivables and inventory items in an amount equal to each property adjusted basis to the partnership, with a decrease required where the basis to be allocated is less than the sum of those bases, and only then to other distributed property (IRC § 732(c)(1))^TY2026

Current figures

How it works in practice

Start with what termination now requires, because the answer is usually that there has not been one. IRC § 708(b)(1) terminates a partnership only where no part of any business, financial operation or venture of the partnership continues to be carried on by any of its partners in a partnership. That is a high bar. A two-partner firm where one partner buys out the other does terminate, because a single owner cannot carry on in a partnership. A ten-partner firm where nine partners are replaced does not, because the business continues and someone is still carrying it on in partnership.

Before 2018 there was a second and much easier way to terminate — a sale or exchange of half or more of the total interest in capital and profits within twelve months — which produced a deemed contribution of assets to a new partnership and a deemed distribution of interests, a short taxable year, fresh depreciation elections and new accounting method choices. It was repealed. A question describing a large transfer of interests and asking whether the partnership terminates is testing that repeal.

IRC § 706(c) is the provision that decides whose year closes, and it separates the entity from the partner. The partnership’s year does not close on a death, an admission, a liquidation or a sale. But it closes with respect to a partner whose entire interest terminates — which is why a deceased partner’s final return picks up their share of partnership income to the date of death, and why a partner who sells their whole interest has a short partnership period. A partner who sells only part of their interest gets no closing at all.

IRC § 736 governs the money paid to a retiring or deceased partner and is the most commonly mishandled provision in this area, because it splits a single payment into two very differently taxed streams. So much of the payment as is for the partner’s interest in partnership property falls under IRC § 736(b) and is a distribution — no deduction to the partnership, and the retiring partner recognises gain only to the extent money exceeds outside basis. Everything else falls under IRC § 736(a) and is either a distributive share or a guaranteed payment — which reduces the continuing partners’ income and is ordinary income to the recipient.

The carve-outs in IRC § 736(b)(2) push amounts out of the property category and into IRC § 736(a). Payments for unrealized receivables and for goodwill are excluded from IRC § 736(b) treatment — but the goodwill exclusion does not apply where the partnership agreement provides for a goodwill payment, and neither exclusion applies at all unless both conditions in IRC § 736(b)(3) are met: capital is not a material income-producing factor for the partnership, and the retiring or deceased partner was a general partner. So the carve-outs reach service partnerships and general partners only. In a capital-intensive partnership, or for a limited partner, everything paid for partnership property stays in IRC § 736(b).

The drafting point that follows is worth stating: whether the agreement provides for a goodwill payment is a real choice. Providing for it keeps the goodwill in IRC § 736(b) — capital treatment for the retiring partner, no deduction for the firm. Silence pushes it into IRC § 736(a) — ordinary income to the retiring partner, and relief for the continuing ones.

The basis rules on liquidating distributions run the opposite way to the ones on contribution. A partner receiving property in liquidation takes a basis equal to their outside basis less any money received, so the partner’s basis is pushed into the property rather than the property’s basis being carried out. Where several properties are distributed, IRC § 732(c) allocates first to unrealized receivables and inventory at the partnership’s basis, and only the remainder to everything else.

Scenarios

How this has changed

The repeal of the technical termination is the defining recent change and it is worth understanding what it removed. Pub. L. 115-97 struck IRC § 708(b)(1)(B), under which a partnership terminated if within a twelve-month period there was a sale or exchange of half or more of the total interest in partnership capital and profits, for partnership taxable years beginning after 31 December 2017. The consequences of a technical termination were substantial and mostly unwelcome: a deemed contribution of all assets to a new partnership followed by a deemed distribution of interests in it, a short taxable year, restarted depreciation recovery periods, and the loss of accounting method and other elections. Practitioners monitored transfer percentages carefully to avoid tripping it. None of that is now necessary.

Two knock-on effects are still visible in the Code and in practice. Reg. § 301.6109-1(d)(2)(iii) still provides that a new partnership formed as a result of a technical termination retains the terminated partnership’s employer identification number — live regulation text for an event that can no longer occur. And partnership agreements drafted before 2018 commonly contain transfer restrictions whose only purpose was to prevent a technical termination; they are now pure friction.

IRC §§ 736 and 732 have not been amended in any way that affects this topic. The IRC § 736(b)(3) limitation — restricting the receivables and goodwill carve-outs to service partnerships and general partners — dates from 1993 and is the change most often overlooked, because material predating it applies the carve-outs to every partnership.

Exam focus

Expect a question that describes a large transfer of partnership interests and asks whether the partnership terminates. The answer is no unless the business itself has stopped, or unless the question is expressly set in a year beginning before 2018.

The second reliable shape is a IRC § 736 division. Work it in order: identify what is being paid for the partner’s interest in partnership property, then check whether any of it is for unrealized receivables or goodwill, then check whether both IRC § 736(b)(3) conditions are met before applying the carve-outs, then ask whether the agreement provides for goodwill.

For basis questions on a liquidating distribution, the answer is the partner’s outside basis reduced by money received — not the partnership’s basis in the property. The partnership’s basis is the answer only for a current distribution, and even then it is capped at outside basis.

Check yourself

1. In March 2026, 65 percent of the interests in a partnership’s capital and profits are sold to new partners. The business continues unchanged. Does the partnership terminate?

Answer: no. IRC § 708(b)(1) terminates a partnership only where no part of its business, financial operation or venture continues to be carried on by any of its partners in a partnership. The rule that would have terminated it on a transfer of 50 percent or more within twelve months was struck by Pub. L. 115-97 for partnership taxable years beginning after 2017.

2. A partner dies on 30 June. Does the partnership’s taxable year close?

Answer: not as to the partnership, but yes as to that partner. IRC § 706(c)(1) provides that the partnership’s taxable year does not close as the result of the death of a partner. IRC § 706(c)(2)(A) closes it with respect to a partner whose entire interest terminates, so the decedent’s share to the date of death is reported on the final individual return.

3. A retiring general partner of a partnership in which capital is not a material income-producing factor is paid $200,000 for her share of unbilled receivables. How is it treated?

Answer: as a IRC § 736(a) payment. IRC § 736(b)(2)(A) excludes payments for unrealized receivables from treatment as payments for an interest in partnership property, and both conditions of IRC § 736(b)(3) are met — capital is not material and she was a general partner. The amount is therefore a distributive share or a guaranteed payment: ordinary income to her, and it reduces the continuing partners’ income.

4. The same partnership pays her $400,000 for goodwill, and the partnership agreement expressly provides for a payment with respect to goodwill. How is that treated?

Answer: as a IRC § 736(b) payment. The goodwill exclusion in IRC § 736(b)(2)(B) applies “except to the extent that the partnership agreement provides for a payment with respect to good will”, and this agreement does. The $400,000 is therefore a payment for her interest in partnership property, treated as a distribution — capital treatment for her, and no deduction for the partnership.

5. A partner with an outside basis of $150,000 receives, in liquidation of his entire interest, $40,000 of cash and equipment with an adjusted basis to the partnership of $220,000. What is his basis in the equipment?

Answer: $110,000. Under IRC § 732(b) the basis of property other than money distributed in liquidation is the adjusted basis of the partner’s interest reduced by any money distributed in the same transaction — $150,000 less $40,000. The partnership’s $220,000 basis in the equipment does not carry over, and no gain arises under IRC § 731(a)(1) because the money did not exceed his basis.