Succession planning – Tax implications of buying or selling in a partnership

Note: Originally published in April 2024, this article has been updated as part of our ongoing series on the tax implications of succession planning. See our related articles on S corporations and C corporations for additional insights.

This article will help you understand the tax implications for both buyers and sellers involved in the purchase or sale of ownership units or assets of a tax partnership, which are most often formed as a limited liability company (LLC). Whether you’re looking to buy or sell, informed decision-making starts with thorough evaluation and planning.

Buying or Selling Partnership Units

In most cases, when a buyer acquires partnership units, they receive a step-up in basis in the underlying assets and liabilities of the partnership. Meanwhile, the seller recognizes a combination of ordinary income and capital gains, based on the nature of the underlying assets and liabilities. The specific mechanisms for achieving a step-up and implementing character of income vary based on the transaction structure.

If the buyer purchases 100% of the partnership, the IRS treats the transaction as a deemed purchase of the underlying assets under IRS Revenue Ruling 99-6 (with respect to the buyer). However, if the buyer acquires less than 100% of the partnership, the IRS considers it a purchase of equity interests rather than a direct asset acquisition.

Understanding 100% Partnership Unit Sales and IRS Revenue Ruling 99-6

This ruling outlines two common scenarios:

Situation One: When a partnership is owned by two partners and one purchases the entire interest of the other partner, the acquiring partner is treated as buying half the assets and contributing the other half to a newly formed partnership. This creates two holding periods: one with a step-up in basis and one with a carryover basis. The seller calculates gain as if the assets were sold, with some of the gain potentially taxed as ordinary income on certain assets like depreciation recapture, inventory, or accounts receivable, commonly referred to as hot assets.

Situation Two: Two partners sell their entire interest to an unrelated buyer. As in situation one, the sellers will calculate the gain based on the underlying assets of the partnership, with some of the gain classified as ordinary and some as capital. The buyer will receive a step-up in basis in the assets. Buyer and seller will allocate the purchase price across the acquired assets by class.

Understanding Partial Partnership Unit Sales

In a partial interest sale, the buyer may be eligible for a step-up in tax basis if the partnership makes an election under Internal Revenue Code (IRC) Section 754. When this election is made, IRC Sections 734 and 754 allow the LLC to adjust the purchasing partner’s share of the basis in the partnership’s assets. This adjustment enables the buyer to claim future depreciation or amortization deductions based on the purchase price.

Although the detailed rules can be complex, these elections play an important role in structuring tax-efficient transactions, particularly when allocating purchase price to depreciable or amortizable assets.

Seller Tax Impacts: Hot Assets

When selling interest in an LLC, sellers need to be aware of the hot asset rules, which require gains to be taxed as ordinary income instead of capital gains. For instance, items like unpaid customer invoices (cash-basis receivables) fall into this category and are taxed at the seller’s ordinary income rate.

However, these rules aren’t always symmetrical. Depending on the situation, sellers may not be able to deduct unpaid bills or accrued expenses, including transaction costs, to offset that income. Without careful planning, this can lead to a higher tax burden than expected.

The table below outlines common hot assets and their associated tax treatment:

Buying or Selling Partnership Assets

An asset transaction involves the transfer of individual assets or a group of assets from one business to another. The buyer may form a new entity to acquire the assets or use an existing business to absorb them into current operations.

Buyer Tax Considerations

• Receives a step-up in basis in the tangible and intangible assets to fair market value based on the purchase price, including any assumed liabilities.
• Tangible assets can generally be deducted as ordinary expense or through depreciation over a short period.
• Intangible assets must be amortized over a 15-year period from the transaction date.

Seller Tax Considerations

• Will recognize ordinary income and capital gain income based on how the purchase price is allocated.
  
  • Ordinary income is taxed at the seller’s regular income tax rate.
  • Capital gain is generally taxed at the long-term capital gains rate of 20%.
• May be subject to the 3.8% Net Investment Income (NII) tax.
• If the seller lives in a state with an income tax:
  
  • Pass-through income will be taxed at the state level.
  • Some states may offer exemptions for certain pass-through gains.

Purchase Price Allocation in Partnership Sales

One of the main points of contention in the sale of a partnership is the allocation of the purchase price.

• The buyer typically prefers to allocate more of the purchase price to ordinary income items such as furniture, fixtures, and equipment (FF&E). These items can often be deducted more quickly through cost of goods sold (COGS) or accelerated depreciation.
• The seller, on the other hand, generally aims to allocate more to intangible assets and goodwill, which are taxed at the lower capital gains rates.

Both parties should agree on a clear methodology before closing. Vague or open-ended allocation terms can lead to unexpected tax consequences.

How State Taxes Affect Partnership Sale Outcomes

There are often significant differences in how states tax a sale of equity versus a sale of assets, which can make a material difference in the tax obligations of the partners. A sale of partnership assets is more often subject to state taxation based on the operations of the business, whereas a sale of partnership equity is more often subject to state taxation based on the residence of the partner. Depending on where the business operates and where the partners reside, the chosen transaction structure can significantly impact state tax obligations.

Additionally, asset sales may allow the seller to subject its gain to a pass-through entity (PTE) tax election, whereas equity sales may not.

For more information on what to do before you go to market, review our sell-side advisory checklist.

We Can Help

At Elliott Davis, our High Net Worth and Transaction Advisory teams draw on years of experience to guide clients through the complexities of buying or selling a business. We work closely with you to evaluate available transaction structures, understand the tax implications of each, and choose the most strategic path forward for you and your business.

Contact us today to get started.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.‍