Deductible payments to departing partners - the RRA and its impact on LLCs.

Prior to the Revenue Reconciliation Act of 1993 (RRA), a partnership had great latitude in structuring payments to a retiring or deceased partner to maximize the combined tax benefits to both parties. The partnership and departing partner were free to determine whether the transaction was to be treated as a purchase of the partner's interest by the remaining partners under Sec. 736(b)(1) (generally resulting in capital gain or loss to the departing partner) or as a liquidating distribution under Sec. 736(a) (generally resulting in the payments being taxed as ordinary income to the departing partner and being deductible by the partnership). The courts have generally held that the parties in such situations are free to structure the transaction either as a sale or a liquidation of the departing partner's interest.

The RRA modified Sec. 736(b) by severely limiting the ability of a partnership to structure deductible payments to a retiring or deceased partner. These new restrictions generally apply to partnerships in which capital is a material income-producing factor or to payments made to other than a general partner. It appears that this latter restriction may have unintended negative consequences for certain limited liability companies.

Sec. 736 treatment - prior

law

The special rules governing the treatment of payments made in redemption of a retiring or deceased partner's partnership interest are found in Sec. 736, which divides these distributions into two categories: (1) Distributions made in exchange for a partner's interest in partnership assets; and (2) distributions made not in exchange for partnership assets, but rather as allocations of partnership net income or as guaranteed payments.

Liquidating payments made in exchange for partnership property are treated as distributions by the partnership under Sec. 736(b), and generally result in gain to the retiring partner only to the extent the cash distributed exceeds the partner's adjusted basis in his partnership interest. This gain is considered capital gain unless a portion of the payment is attributable to the departing partner's share of the partnership's substantially appreciated inventory or unrealized receivables (as defined under Sec. 751). Such a payment is not deductible by the partnership or by the remaining partners.

An exception to Sec. 736(b) treats amounts paid for goodwill and unrealized receivable of the partnership as not being made in exchange for an interest in partnership property (Sec. 736(b)(2)), thereby making such amounts deductible to the partnership and ordinary income to the departing partner. Unrealized receivables are defined under Sec. 751(c) to include unbilled amounts for goods begun or services provided, cash basis accounts receivable and depreciation recapture; deductible payments for goodwill are available only if the partnership agreement does not provide for a payment for goodwill. By permitting a payment for unstated goodwill and unrealized receivables to be considered similar to a guaranteed payment or distributive share, this special rule permits a deduction for an amount that would otherwise constitute a capital expenditure.

Alternatively, a liquidating payment not made in exchange for a partner's interest in partnership property will be treated in one of two ways. If the amount of the payment is determined without reference to partnership income, it is treated as a guaranteed payment to the partner and is deductible by the partnership under Sec. 736(a)(2). If the amount of the payment is determined by reference to partnership income, it is treated as a distributive share of the partnership's income, thereby reducing other partners' taxable distributive shares (Sec. 736(a)(1)). This allocation of a portion of the partnership's distributive share of income is equivalent to a deduction for the other partners.

In other areas of the Code, a current deduction is generally not allowed for capital expenditures. Specifically, goodwill acquired in connection with the assets of a going concern is considered a capital expenditure and, prior to the enactment of new Sec. 197, was not deductible until the business and related goodwill were sold or otherwise disposed of. Even under Sec. 197, the cost of acquiring goodwill must be amortized over 15 years. Similarly, the cost of acquiring accounts receivable is considered part of the tax basis of these receivables and is taken into account when the receivables are collected, disposed of or become worthless. Thus, allowing a partnership a deduction for amounts paid for unstated goodwill and unrealized receivables represents a significant tax benefit not generally available elsewhere in the Code.

The RRA

This special treatment of allowing partnerships a current deduction for the acquisition of goodwill and unrealized receivables under Sec. 736(b) was perceived as abusive because it afforded taxpayers the ability to deduct currently what would otherwise be capitalizable costs. In response to this perceived inequity, Sec. 736(b)(3) generally repeals the special treatment of liquidation payments made for unstated goodwill and unrealized receivables. Consequently, such payments are now treated as capital expenditures made in exchange for the partner's interest in partnership property and not as a distributive share of partnership income or as guaranteed payments.

The amendments made by the RRA do not, however, change the prior law with respect to payments made to a departing general partner in a partnership in which capital is not a material income-producing factor. The committee reports state that, for purposes of this provision, capital is not a material income-producing factor when substantially all of the gross income of the business consists of fees, commissions or other compensation for personal services performed by individuals. The professional practice of a doctor, dentist, lawyer, architect or accountant will not be treated as a trade or business in which capital is a material income-producing factor, even though the practitioner may have a substantial capital investment in professional equipment or in the office from which the individual conducts the professional practice, so long as such capital investment is merely incidental to the professional services being rendered.

The repeal of the beneficial tax treatment for partnership redemption payments (other than to general partners in personal service partnerships) will eliminate partnership deductions for the acquisition of unrealized receivables and unstated goodwill on the complete liquidation of a partner's interest. The change is effective for partners retiring or dying on or after Jan. 5, 1993. It does not apply to partners retiring on or after this date if a written contract to purchase such partner's interest in the partnership was binding on Jan. 4, 1993, and at all times thereafter.

Impact on LLCs

With the recent explosion of limited liability company (LLC) legislation throughout the country, many organizations are considering LLCs for their business operations. The LLC is an especially attractive business entity for existing partnerships, since it provides limited liability protection for all of the owners. In addition, if the LLC is treated as a partnership for Federal tax purposes, the conversion of a partnership to an LLC can generally be done on a tax-free basis.

Due to the continuing increase in malpractice claims being brought against professionals, many personal service partnerships are being converted to LLCs in states that permit professional LLCs. In the majority of these states, an LLC will protect its members from malpractice claims made against other members of the professional LLC (but not against the member's own acts of malpractice).

In most states, a member of an LLC has no personal liability for claims by creditors in excess of the member's investment in the LLC unless the member has personally guaranteed certain debts or has committed the act of malpractice. In light of this state law protection, a member of an LLC will presumably not be considered a "general partner" for tax law purposes. If this presumption is correct, the repeal of the special treatment for liquidation payments made for unstated goodwill and unrealized receivables will affect payments to departing LLC members. Since the exception to the repeal of this provision requires that the retiring or deceased partner be a general partner in the partnership, this requirement may not be satisfied in an LLC. Therefore, this RRA change presents a significant disadvantage to personal service partnerships considering converting to professional LLCs.

This 1993 change in Sec. 736(b) does not affect the deductibility of compensation paid to a retiring partner for past services. Thus, proper planning for the payment of deferred compensation to retiring or deceased partners will take on greater importance if he partnership is not a personal service business or if the personal service organization operates as an LLC.

Practitioners are hopeful that Congress will eliminate the general partner requirement for currently deductible payments for unstated goodwill and unrealized receivables for personal service LLCs in a future technical corrections bill. If the 1993 changes were, in fact, not designed to negatively affect LLCs, such a technical correction would be fair and proper and should be treated as a priority item in future legislation.